A time deposit is one of the basic investment strategies.
In a time deposit, you put a certain amount of money in a bank account for
an amount of time and interest that are normally fixed. This means you can
compute exactly how much money you have at the end.
One reason for using time deposits is in the case an investor knows he
will need a certain amount at a certain date. For instance, he knows he
needs to pay tuition in nine months. Say the tuition is M dollars,
and say the interest rate is r. The time t is known and is
equal to 0.75. He would then need to put M/(1+rt) dollars in a time
deposit to get exactly M dollars out. This is roughly equal to
M*(1-rt). With compound interest, the correct formula becomes
M/(1+r)t. In other words, M deposited grows to
M/(1+r)t in time.
Deposits also may play an important role in options. Imagine I
have a call option that allows me to buy a share for $10; the current
stock price is $40. This means I'll almost certainly buy the share. Say I
have enough options to buy 1000 shares; this means I'll need a cool $10,000
to complete the transaction. Again, I can put _M/(1+rt)_ in a time deposit
to buy the shares. The only risk here is that the share price drops below
$10; in this case, I won't exercise the call, but the money is still locked
up.
Okay, so we can put money in a time deposit. Great. Why just not put
money in the bank on a normal savings account? What is the difference?
Well, there are three main differences.
The first difference is that in principle, a customer cannot get his
money out in the mean while in a time deposit. The two main exceptions here
are the fact that some banks allow the customer to to get his money out
under special circumstances, such as death or unemployment. Secondly, it
is usually possible to withdraw the money upon paying a penalty. Read the
small print; it's usually different for each bank.
Secondly, the interest rate on your savings account is normally
floating, while the interest on the time deposit is
fixed. This means one cannot be surprised with rate cuts
while one has a time deposit. The flip side is that rate hikes don't make any money. Hence, a time deposit may be
favorable if one expects a rate decrease, and less favorable if one expects
a rate decrease
Thirdly, the interest rate is different because of the yield curve.
Without going into too much detail, we can state that normal yield
curve, the interest rate for short-term loans is lower than that for
long-term loans. Because the time deposit allows the bank to loan the money
long-term, i.e. for the duration of the time deposit, we expect the interest
rate on long-term time deposits to be higher. This is in addition to the fact
that more interest accrues due to the longer duration. A savings account is
essentially a one-day deposit (money can be withdrawn daily) and hence
should have a lower interest rate.
With these differences, an investor can now decide whether to pick a
time deposit or a savings account. If the investor is sure he
doesn't need the money in the short run, a time deposit will normally give a
higher interest rate and is hence preferable. In particular, a combination
of shorter-dated and longer-dated time deposits can be considered.
The main risks associated with time deposits are a market risk
and a credit risk. The market risk here is that interest rates may rise,
and having a savings account would have been better after all. Because of
the edge even a yearly time deposit has, this is fairly unlikely, and it
is even more unlikely the difference would be really substantial. The main
risk here is credit risk: the bank might get in trouble and the investor
can't get out. This, in part, is the reason why longer-dated deposits have a
higher yield: the higher yield compensates for this risk
The astute reader might have noticed that this structure is in principle
no different from a bond. This is correct! However, a bond has one
important advantage and one important disadvantage. The advantage of the
bond is that it may be tradeable. Want your money out? Sell the
bond. The main disadvantage is that deposits are usually
government-guaranteed, and bonds are not. Especially given that deposits are
usually intended as a risk-free investment, this default risk on the
bond is usually very unwelcome. It can be avoided by buying government bonds, but these might be unwieldy because of their
normally very large size.
Summarizing, we can state that time deposits are a way of
saving money for a fixed amount of time and a fixed interest rate. They
usually yield more than a normal saving account, but the disadvantage is
that the investor cannot (easily) get the money out in the meanwhile. They
are in principle identical to bonds, but are less unwieldy and less
risky for small investors