What Is a Callable Certificate of Deposit?
For a bank, selling certificates of deposit is a relatively cheap way to expand its reserve base. By offering a rate of return significantly higher than what's available on a savings account, the bank can entice investors to park substantial sums of money for a prescribed period of time. The call feature allows the bank to terminate the agreement early.
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Function
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Traditional CDs have a set maturity date, before which the CD cannot be redeemed without substantial penalty. Adding a call feature to the CD doesn't give the depositor the opportunity to access the CD funds before the maturity date, but it gives the bank the option to cancel the agreement before the maturity date.
Types
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The details of the call feature vary widely. Some callable CDs are callable only during an initial period, such as during the first year. Some are callable only after an initial period, or up to a certain time before the maturity date, and others have a revolving, periodic call window. It is rare to ever find a callable CD, however, that is not structured with a limited window for the bank to exercise its call option.
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Effects
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The terms of the call obviously dictate its effects, but in general, the result is that the depositor does not realize the returns originally expected on the CD investment. If there is a fixed price for the call, the result may be the investor not even receiving all the interest that would have accrued. In any event, however, the investor should always receive the full amount of the initial deposit and most, if not all, of the interest that has accrued up to the call.
Function
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Deciding to call in a CD is simply a smart business decision on the part of the bank. If prevailing interest rates move in the bank's favor--that is, lower--the existing CD paying out at the higher rate is more expensive than new business. It then makes sense to call the CD and replace it with a new one at the lower rate, whether through the same depositor or a new customer.
Significance
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Because depositors can be understandably annoyed by the exercise of the call function on certificates of deposit, banks have come to emphasize variable-rate CDs that automatically reset at lower rates if rates decline. These are often linked to the yield of a treasury bill or note with a similar maturity, giving the depositor the potential to benefit from rising rates without necessarily affecting the bank because a spread is maintained through which the bank can continue to profit.
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