Citibank Equity Linked CD: A Detailed Analysis and Evaluation

This assignment analyzes Citibank's Equity Linked Certificate of Deposit (CD). It examines the product's features, including how the return is calculated based on the S&P 500 index performance. The assignment requires creating a visual representation of the investor's payoffs, calculating the cost to the investor compared to a regular CD and an S&P 500 index fund, and explaining the motivations of both the investor and Citibank for engaging in this product. Furthermore, the assignment explores the risk exposure of the bank and potential hedging strategies, concluding with a comparison between the simplified and actual options underlying the CD.

CITIBANK EQUITY LINKED CD
In the attached newspaper page advertising Citibank’s “Stock Index Insured Account”,
the bank promises “Stock Market Returns. Zero Risk to Principal.” In describing how it works,
the advertisement explains that:
 The bank calculates the month-end average of the S&P 500 index average over the next
five years, i.e. the average of 60 month-end S&P 500 index values.
 The bank takes the difference of the month-end average S&P 500 price and the value of
the S&P 500 at the time of the deposit. If the difference is positive, i.e. the S&P has
appreciated; the investor receives double the amount of the appreciation. If the difference
is negative, i.e. the S&P has depreciated; the investor gets back the initial amount
invested.
To make things simpler, assume that the bank simply offers to give the difference between the
S&P 500 value at the end of five years and the initial index value if the S&P 500 appreciates (i.e.
no averaging or doubling). If the S&P 500 depreciates, the investor gets back the initial
principal.
a. Draw a picture representing the payoffs to the investor.
b. What is the cost to the investor for buying this product? For example, consider
what the investor loses in comparison to a regular CD? Similarly, what does the
investor lose in comparison to an investment in the S&P 500 Index Fund?
c. Explain why an investor might be interested in this product. Why would Citibank
offer such a product?
d. What is the risk exposure to the bank from offering this product? How might the
bank hedge this risk exposure?
e. Discuss the difference the option that truly underlies the CD and the simplified
version of the option that I you have analyzed.