Yield Measures on Bank Certificates of Deposit

ByShahid Siddiqui

 

 

Yield Measures on Bank Certificates of Deposit

Suppose an investor is comparing the following two money market instruments. Which offers the higher expected rate of return, assuming that credit risks are the same?

  • A 90-day commercial paper (CP) issued by Bright Wheel Automotive Corporation (BRWA), quoted at a discount rate of 0.100% for a 360-day year.
  • A 90-day certificate of deposit issued by CFP Bank, quoted at an add-on rate of 0.120% for a 365-day year.

Step 1: Calculate the Price of the Commercial Paper

The price of the commercial paper is calculated using the formula:

PV = FV × (1 – (Days / Year) × DR)

Substituting the values (FV = 100, Days = 90, Year = 360, DR = 0.0012):

PV = 100 × (1 – (90 / 360) × 0.0012)
PV = 99.970

Step 2: Convert the Discount Rate to an Add-On Rate

Using the add-on rate formula:

AOR = (Year / Days) × (FV – PV) / PV

Substituting the values (Year = 365, Days = 90, FV = 100, PV = 99.970):

AOR = (365 / 90) × (100 – 99.970) / 99.970
AOR = 0.00122 (or 0.122%)

Conclusion

The 90-day commercial paper discount rate of 0.120% converts to an add-on rate for a 365-day year of 0.122%. This converted rate is called a bond equivalent yield, or sometimes just an “investment yield.” A bond equivalent yield is a money market rate stated on a 365-day add-on rate basis. If the risks are the same, BRWA’s CP offers 0.2 bps more in annual return than CFP Bank’s CD.

 

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