CDPUT In an article in the March 1986 AAII Journal, Mark Kimmitt suggested an intriguing investment tactic--the CD "put." The basic idea is that whenever CD rates rise above a certain point, holders of non- negotiable savings certificates of deposit will find it advantageous to cash in--"put"--their CDs, pay the early withdrawal penalties, and reinvest the proceeds at the new higher rates. During periods of rising interest rates, investors will earn a greater return "ratcheting" upward their time certificates in this way than if they simply hold them, locked into their original rates, until maturity. The interest rate at which the added interest income exactly offsets the early withdrawal penalty is called the CD's "breakeven point." Mr. Kimmitt's equation for determining the breakeven point assumes annual compounding and integral, yearlong time periods. But what if a CD compounds quarterly or daily? Or what if you are 2-1/2 years into the life of a five-year CD? How then do you calculate the breakeven point? In cases such as these, the breakeven rate can no longer be solved for directly, and an iterative, approximative method must be used. The program that follows, "CDPUT," employs such a method. It will determine any CD's breakeven point and allow you to estimate the potential profit (or loss) in "putting" that CD. The program asks for the investment principal, the original interest rate, the number of compounding periods per year, the CD's term (in months and years), and the early withdrawal penalty (in months of lost simple interest). Since the Federal Reserve no longer requires that early-withdrawn CDs will have earned interest at a rate no greater than the regular passbook savings rate, few if any savings institutions now offer CDs under that condition. However, in cases where they do, and for existing CDs purchased before the Federal Reserve requirement was suspended, the program also takes into account that possible additional penalty. The program then asks for the month and year of purchase as well as the current month and year. With that, it determines the months and years remaining to maturity and asks you to input the current rate being offered on custom term ("flex term") CDs of comparable maturity. If your savings institution doesn't offer custom term or fractional year CDs, input the rate on CDs of the next longest maturity. For instance, given one year and seven months remaining to maturity, enter the rate for a two-year CD. (Although the "CDPUT" program is precise about time only to the nearest month, specifying time to the exact day serves little purpose, as the computed breakeven point comes out more or less the same.) You might think that, because the early withdrawal penalty is tax- deductible, there is a tax advantage to "putting" a CD, but in actuality the advantage is only slight. To see why, consider the following. A $10,000 five-year CD with a terminal value of $15,000 will have earned you $5,000 in taxable interest income if held to maturity. Suppose instead that after two years, with the deposit now worth $11,750, you decide to cash in the CD, pay an $850 interest penalty, and reinvest the remaining $10,900 at the breakeven rate. After three more years, this second CD will also have a terminal value of $15,000. In spite of the tax deduction, the total taxable interest income still equals $5,0000: ($11,750 - $ 10,000) - the $850 tax deduction + ($15,000 - $10,900). Whether you hold or whether you "put" (and reinvest at the breakeven rate), the total tax bill is the same. (Since the tax deduction allows you, in effect, to defer payment of taxes on $850--i.e., you will still pay taxes on that amount of income, but in installments over the next three years rather than right away--there is in fact a slight tax advantage to "putting" the CD, but it is of little practical significance.) An example. Suppose that in September 1984 you invested $10,000 in a five-year CD earning an 11.5% annual rate and compounding quarterly. The only penalty for early withdrawal is three months' lost simple interest. Suppose also that it is now June 1986, hence the CD is three years and three months short of maturity, and the current interest rate for a CD with a comparable maturity is 13%. Let's run the program through this example: CD PRINCIPAL VALUE ($)? 10000 ORIGINAL CD INTEREST RATE (%)? 11.5 NO. COMPOUNDING PERIODS PER YEAR? 4 CD TERM (YEARS, MONTHS)? 5,0 EARLY WITHDRAWAL PENALTY (MONTHS)? 3 DOES THE CD RATE REVERT TO THE PASSBOOK RATE UPON EARLY WITHDRAWAL? NO MONTH & YEAR OF CD PURCHASE? 9,1984 CURRENT MONTH & YEAR? 6,1986 FOR A CD WITH 3 YEARS, 3 MONTHS REMAINING TO MATURITY, COMPOUNDING 4 TIMES ANNUALLY, WHAT IS THE CURRENT INTEREST RATE (%)? 13 TERMINAL VALUE OF HOLDING ($): 17627.74 TERMINAL VALUE OF PUTTING ($): 18045.88 TV(PUTTING) - TV(HOLDING) ($): 418.14 BREAKEVEN RATE (%): 12.26 If you hold your current CD until maturity, its terminal value (before taxes) will be $17,627.74. If you exercise the "put" option and reinvest at 13%, the terminal value will equal $18,045.88, or $418.14 more than if you hold. The breakeven rate is 12.26%. If, instead, current rates were below the breakeven rate (hence you would lose by "putting" the CD) but they subsequently rise to 12.26%, you should wait awhile before exercising the "put." There are two reasons for this. First, you should wait until interest rates rise high enough to compensate for any transactions costs involved (bank fees, the cost of the time and bother spent exercising the "put," etc.). Second, rates might go appreciably higher in the near term. You would not want to "put" your current CD and reinvest at 12.5% when a month or two later you might be able to reinvest at 13% or 14%. If interest rates continue to decline as they have over the last seven years, then the CD "put" is for now but a theoretical curiosity. If, however, rates prove to be at or near their cyclical lows and are headed back up in the near future, barring another change in the Federal Reserve regulations, the CD "put" becomes a viable investment tactic. Immediately relevant or not, the "CDPUT" program demonstrates once again the potential usefulness of the computer as an investment tool. Robert Osterlund