Bank Discount Rate: What it is, How it Works, Example (2024)

What Is the Bank Discount Rate?

The bank discount rate is the interest rate for short-term money market instruments like commercial paper and Treasury bills. The bank discount rate is based on the instrument's par value and the amount of the discount. The par value is the face value or original value of the investment when it was first issued. The bank discount rate is the required rate of return for a safe investment guaranteed by a bank.

Key Takeaways

  • The bank discount rate refers to the interest rate an investor will receive for investing in short-term money market instruments such as Treasury bills and commercial paper.
  • By calculating the bank discount rate, an investor can determine the net gain they'll earn on their investment if they hold it until maturity.
  • The bank discount rate is calculated relative to par value, which is the original value or face value of the investment when it was first issued.
  • It's important to note that the bank discount rate uses simple interest, not compound interest, in its calculation.

Understanding the Bank Discount Rate

Calculating the bank discount rate helps investors determine the net gain they'll earn on certain money market investments if they hold the investment until maturity. This net gain is expressed as a percentage of the investment's initial cost. Some securities are issued at a discount to par, meaning that investors can purchase these securities at a price lower than the stated par value.

Treasury bills, which are backed by the full faith and credit of the U.S. government, are pure discount securities. These short-term, non-interest-bearing money market instruments do not pay coupons, but investors can purchase them at a discount and receive the full face value of the T-bill at maturity.

For example, the U.S. Treasury issues a Treasury bill for $950. At maturity, the debtholders will receive the face value of $1,000. The difference between the discount purchase price and the par value is the dollar rate of return. This is the rate at which the central bank discounts Treasury bills, and it is referred to as the bank discount rate.

The bank discount rate method is the primary method used for calculating the interest earned on non-coupon discount investments. It is important to note that the bank discount rate factors in simple interest, not compound interest. In addition, the bank discount rate is discounted relative to the par value, and not relative to the purchase price.

Bank Discount Rate vs. Coupon Rate

The interest rate for U.S. Treasury bills (T-bills) is calculated differently than the interest rate for Treasury notes (T-notes) and Treasury bonds (T-bonds). The interest rate for T-bills comes from the spread between the discounted purchase price and the face value redemption price. This represents the bank discount rate. While T-bills have a low rate of return, they are considered some of the safest investments available.

In comparison, the interest rate for T-notes and T-bonds is based on the investment's coupon rate. The coupon rate is the return paid to the investor relative to the investment's par value. These investments pay investors periodic interest at six-month intervals until maturity. At maturity, the face value of the note or bond is paid to the investor.

Example of Bank Discount Rate

Let's assume a commercial paper matures in 270 days with a face value of $1,000 and a purchase price of $970.

First, divide the difference between the purchase value and the par value by the par value.

($1,000 - $970)/$1,000 = 0.03, or 3%

Next, divide 360 days by the number of days left to maturity. To simplify calculations when determining the bank discount rate, a 360-day year is often used.

360/270 = 1.33

Finally, multiply both figures calculated above together.

3% x 1.33 = 3.99%

The bank discount rate is, therefore, 3.99%.

Following our example above, the formula for calculating the bank discount rate is:

Bank Discount Rate = (Dollar Discount/Face Value) x (360/Time to Maturity)

Special Considerations

Since the formula uses 360 days instead of 365 days or 366 days in a year, the bank discount rate calculated will be lower than the actual yield you receive on your short-term money market investment. The rate should, therefore, not be used as an exact measurement of the yield that will be received.

Bank Discount Rate: What it is, How it Works, Example (2024)

FAQs

Bank Discount Rate: What it is, How it Works, Example? ›

The bank discount rate is the interest rate for short-term money market instruments like commercial paper

commercial paper
Commercial paper is an unsecured, short-term debt instrument issued by corporations. It's typically used to finance short-term liabilities such as payroll, accounts payable, and inventories. Commercial paper is usually issued at a discount from face value. It reflects prevailing market interest rates.
https://www.investopedia.com › terms › commercialpaper
and Treasury bills. The bank discount rate is based on the instrument's par value and the amount of the discount. The par value is the face value or original value of the investment when it was first issued.

What is an example of a bank discount rate? ›

For example, $100 invested today in a savings scheme with a 10% interest rate will grow to $110. In other words, $110, which is the future value (FV), when discounted by the rate of 10%, is worth $100 (present value) as of today.

What does bank rate or discount rate mean? ›

also called: rediscount rate, or bank rate. discount rate, interest rate charged by a central bank for loans of reserve funds to commercial banks and other financial intermediaries.

What is a real life example of discount rate? ›

An investor, for example, can use this rate to calculate how much their capital will be profitable in the future. If one invests $10,000 now, it will be worth around $26,000 in ten years, assuming a ten per cent interest rate.

Why do banks use discount rate? ›

The discount rate is the interest rate at which commercial banks and other depository institutions can borrow reserves from regional Federal Reserve Banks to facilitate short-term adjustments to temporary changes in the structure of their assets and liabilities.

Is A discount rate good or bad? ›

The Bottom Line. High discount rates mean that it's more costly for commercial banks and other financial institutions to borrow money from the Federal Reserve. This can have ripple effects across the economy. High discount rates can increase other interest rates, making it more expensive to borrow money.

Who pays the discount rate? ›

The federal discount rate is the interest rate the Federal Reserve (Fed) charges banks to borrow funds from a Federal Reserve bank from the discount window.

What is the formula for discount rate example? ›

The formula to calculate the discount rate is: Discount % = (Discount/List Price) × 100. For example, if the list price of an item is $80, and a $10 discount is offered on the item, then the discount percent will be (10/80) × 100, which is equal to 12.5%.

What is the current bank discount rate? ›

US Discount Rate is at 5.50%, compared to 5.50% the previous market day and 5.25% last year. This is higher than the long term average of 2.15%.

Who sets the discount rate? ›

The board of directors of each reserve bank sets the discount rate every 14 days. It's considered the last resort for banks, which usually borrow from each other. How it's used: The Fed uses the discount rate to control the supply of available funds, which in turn influences inflation and overall interest rates.

What happens when the federal government raises the discount rate? ›

The net effects of raising the discount rate will be a decrease in the amount of reserves in the banking system. Fewer reserves will support fewer loans; the money supply will fall and market interest rates will rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.

What is an example of a bank discount? ›

Sometimes, a bank will give what is called a discount loan: in this case, interest is deducted at the time the loan is obtained. For example, if we agree to pay a bank $9,000 in 2 years at 6% simple discount, the bank will compute the interest: I = Prt = 9000(0.06)(2) = 1080, then deduct this from the total.

What is the bank discount rate? ›

The bank discount rate is the interest rate for short-term money market instruments like commercial paper and Treasury bills. The bank discount rate is based on the instrument's par value and the amount of the discount. The par value is the face value or original value of the investment when it was first issued.

What is the easiest way to calculate discount? ›

You can calculate the value of a product with a 25% discount on it by using the formula Discount (%) = (25/List Price) × 100. How do you calculate a 15% off? You can calculate the value of a product with 15% off on it by using the formula Discount (%) = (15/List Price) × 100.

What is an example of a real discount rate? ›

Discount Rate Example (Simple)

Below is a screenshot of a hypothetical investment that pays seven annual cash flows, with each payment equal to $100. In order to calculate the net present value of the investment, an analyst uses a 5% hurdle rate and calculates a value of $578.64.

What are the three types of discount rate? ›

The different types of discount rates are Weighted Cost of Capital (WACC), Cost of Equity, Risk-Free Rate, and Cost of Debt.

What is the formula for discount rate in banking? ›

There are two primary discount rate formulas - the weighted average cost of capital (WACC) and adjusted present value (APV). The WACC discount formula is: WACC = E/V x Ce + D/V x Cd x (1-T), and the APV discount formula is: APV = NPV + PV of the impact of financing.

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