Bank Discount Rate

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 depends 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.

Understanding the Bank Discount Rate

Calculating the bank discount rate assists investors with determining the net gain they'll earn on certain money market investments assuming they hold the investment until maturity. This net gain is communicated as a percentage of the investment's initial cost. A few securities are issued at a discount to par, implying 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 don't pay coupons, but investors can purchase them at a discount and receive the full face value of the T-bill at maturity.

For instance, 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 alluded to as the bank discount rate.

The bank discount rate method is the primary method utilized 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 versus 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 viewed as probably the safest investments that anyone could hope to find.

In comparison, the interest rate for T-notes and T-bonds depends 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.

Illustration of Bank Discount Rate

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

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

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

Next, partition 360 days by the number of days left to maturity. To improve on calculations while determining the bank discount rate, a 360-day year is often utilized.

360/270 = 1.33

At last, multiply both figures calculated above together.

3% x 1.33 = 3.99%

The bank discount rate is, therefore, 3.99%.

Following our model over, 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 utilizes 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 ought to, therefore, not be utilized as an exact measurement of the yield that will be received.

Highlights

• The bank discount rate alludes to the interest rate an investor will receive for investing in short-term money market instruments, for example, Treasury bills and commercial paper.
• By calculating the bank discount rate, an investor can determine the net gain they'll earn on their investment assuming they hold it until maturity.
• It's important to note that the bank discount rate utilizes simple interest, not compound interest, in its calculation.
• 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.