Valuing “Raise Your Rate” certificates of deposit

Abstract

Purpose

The “raise your rate” (RYR) certificate of deposit (CD) allows investors to raise the rate on their CD to the current market rate over the life of the CD. The purpose of this paper is to present a binomial option pricing model to value this option to raise the rate. The model also demonstrates conditions under which the investor should choose to exercise their option and raise their rate prior to maturity. Understanding the value of this option is useful to both banks setting rates, and investors comparing alternative investment opportunities. The results of this model suggest that, for CDs with short maturities and low yields, the value of the option is relatively small, roughly one to four basis points, however, for CDs with longer maturities and higher yields the value of the option can be as much as 50-80 basis points.

Design/methodology/approach

This paper demonstrates how to value raise your rate CDs by applying a binomial option pricing model and provides the value of this option over a range of current CD yields and over a range of CD maturities.

Findings

When CD rates are low and maturities are short the value of the option is small (one to four basis points), however, when CD rates are high with longer maturities, the value of this option can be significant (50-80 basis points).

Research limitations/implications

The research implication is that the rate discount that the institution offers and the investor accepts should reflect the value of the option to raise the rate. The benefit to the institution and the cost to the investor reflected in the rate discount can be determined by the procedures presented in this paper regarding the valuation of the option to raise the rate.

Practical implications

The purpose of this paper is to demonstrate how to apply a binomial option pricing model to value the option that is attached to a raise your rate CD. Knowing the value of this option should be useful both to banks, in determining the discounted rate they should offer on these CDs, and to investors choosing among alternative investment opportunities. An additional benefit of applying a binomial model to value the option is that the model can be used by investors to determine the optimal point at which to exercise their option and lock in the current higher rate.

Social implications

Given the recent financial turmoil, pressure has been placed on banks to increase their liquidity and deposit base. CDs are crucial to this. Understanding the value of the RYR option is useful to both banks setting rates and investors comparing alternative investment opportunities.

Originality/value

Given the current economic climate, deciding which strategic investment options to pursue is of paramount importance. To the best of the knowledge this is the first study that applies binomial option pricing to certificates of deposit to help investors make these decisions.

Citation

Brous, P., G. Buchanan, B. and Orcutt, T. (2014), "Valuing “Raise Your Rate” certificates of deposit", Managerial Finance, Vol. 40 No. 9, pp. 864-882. https://doi.org/10.1108/MF-11-2013-0317