Discount rate

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For the interest rate charged to banks for borrowing short-term funds directly from the Federal Reserve, see discount window.

The discount rate is a near synonym of interest rate. It can be used in three different senses:

  • in a narrow technical sense, in the mathematics of finance, as an alternative calculation of the interest rate whereby the divisor in the interest rate formula is the original investment (see example below).
  • in a general sense, as meaning the same as interest rate.
  • to refer specifically to the interest rate on Treasury Bills and similar financial instruments, since the interest rate on such instruments has historically been expressed arithmetically using the approach set out above (ie with the divisor being the original investment).

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[edit] Example

Suppose there is a government bond that sells for $95 and pays $100 in a year's time. The discount rate represents the discount on the future cash flow:

\frac{100-95}{100} = 5.00\%

The interest rate on the cash flow is calculated using 95 as its base:

\frac{100-95}{95} = 5.26\%

For every interest rate, there is a corresponding discount rate, given by the following formula:

d = \frac{i}{1+i}

inversely,

i = \frac{d}{1-d}

[edit] ..

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One major issue of economic policy is how to determine an appropriate discount rate. Because the discount rate can have a dramatic effect on central reserve banking systems (including several levels of supporting institutions: private banks, corporate investments) the numerous trends that affect these subgroups subsequently affect the best possible discount rate.

A low discount rate is often preferred by governments attempting to stimulate an economy; a lower discount rate makes money cheaper for banks which then have greater lending power. The validity of this method for affecting market growth has been challenged, but retains its place in policy for the current Chinese administration.

[edit] Business calculations

Businesses need to consider the discount rate when deciding whether to spend some of their profits on buying a new piece of equipment, or whether to give the profit back to their shareholders. In an ideal world, they would only buy a piece of equipment if the shareholders would get a bigger profit later. The amount of extra profit that a shareholder requires in the future in order to prefer that the company buys the equipment rather than giving them the profit now is based on the shareholder's discount rate. There is a widely used way of estimating shareholder's discount rates using share price data. It is known as the capital asset pricing model. Businesses normally apply this discount rate to their decisions about purchasing equipment by calculating the net present value of the decision.

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