Weighing the Risks Involved in Indexed CDs

Index-Linked certificates of deposit are very similar to the certificates of deposit except for the fact that they are indexed to the stock market. Indexed CD’s are FDIC insured for up to a sum of $250,000.  In case of a failure by way of seizure or a bank closure, the money is safe as FDIC offers a 100% guarantee in this case.  The Federal Deposit Insurance Corporation assures 100% coverage for its clients.

It was the assumption that stocks were headed North until the collapse of Wall Street in the year 2008 and many suffered financial losses of large sums of money.  This has made the conservative investor a little wary.  Hence, it would help to know some truths about indexed CD’s, weigh the risks before taking the plunge.

Indexed CD’s are offered by or sometimes sold by financial advisers.  They could be indexed to bonds, currencies, commodities etc.  It is also a well known fact that they offer higher returns, than a savings account or a checking account, or treasury securities and that coupled with the added coverage by FDIC makes it an interesting investment option.  The director of Wharton Wealth Management Initiative, University of Pennsylvania, Chris Geczy, states that this makes it an attractive option for investors who are worried about the management of the downside risks in their investment portfolios.

The rate at which interest is calculated differs in CD’s as well as indexed CD’s.  While CD’s have a set interest rate for a stipulated time period, Indexed CD’s calculate the interest based on the performance of the Index that the CD is linked to.   If it is indexed to the Dow Jones industrial average or the S&P 500 then the investor receives part of the increase if the index rises.  While, if there is a fall in the index, the principal is protected but the investor gets little or no interest.

While in the case of the CD, one can liquidate it before the date of maturity in turn, losing out on a little interest, but the principal amount will be returned.  But in case of an indexed CD, if it is liquidated before the date of maturity, there is no guarantee that the principal amount will be returned in full.

The simplest way to calculate is a point-to-point approach wherein one takes into account the value of the index at the beginning as well as the end of the term of the Indexed CD.  There are also a lot of variations in the participation rate.  A 75% participation rate could fetch a return of 7.5% if there is a 10% increase in the index.  This rate is also subject to vary from one CD to another.