What Is the Bank Discount Rate?

The bank discount rate signifies the interest rate associated with short-term money market instruments such as commercial paper and Treasury bills. This rate is determined based on the instrument’s par value and the discount amount. Par value denotes the face value or original value of the investment at its issuance. Essentially, the bank discount rate represents the required rate of return for a safe investment backed by a banking institution.

Key Takeaways

• The bank discount rate pertains to the interest rate an investor earns when investing in short-term money market instruments like Treasury bills and commercial paper.
• By computing the bank discount rate, an investor can ascertain the net gain they will achieve on their investment upon maturity.
• The bank discount rate is computed relative to the par value, which is the initial or face value of the investment when first issued.
• It is crucial to note that the bank discount rate employs simple interest in its calculation, not compound interest.

Understanding the Bank Discount Rate

Calculating the bank discount rate aids investors in determining the net gain they stand to earn on certain money market investments if held until maturity. This gain is represented as a percentage of the investment’s initial cost. Some securities are issued at a discount to par, allowing investors to purchase them below the stated par value.

Treasury bills, supported 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 offer coupons but enable investors to buy them at a discount and receive the full face value at maturity.

For instance, when the U.S. Treasury issues a Treasury bill for $950, debtholders will receive the $1,000 face value upon maturity. The disparity between the discount purchase price and the par value constitutes the dollar rate of return, known as the bank discount rate.

The bank discount rate method is the predominant approach for determining the interest earned on non-coupon discount investments. Notably, the bank discount rate relies on simple interest and is discounted concerning the par value, not the purchase price.

Bank Discount Rate vs. Coupon Rate

The interest rate for U.S. Treasury bills (T-bills) differs from that of Treasury notes (T-notes) and Treasury bonds (T-bonds). T-bills’ interest rate is determined by the spread between the discounted purchase price and the face value redemption price, which delineates the bank discount rate. Despite offering a low rate of return, T-bills are viewed as extremely secure investments.

Conversely, the interest rate for T-notes and T-bonds is based on the coupon rate of the investment. The coupon rate signifies the return paid to the investor relative to the investment’s par value. Investors in these securities receive periodic interest at six-month intervals until maturity, at which point they are repaid the face value.

Example of Bank Discount Rate

Let’s consider a scenario where a commercial paper with a face value of $1,000 matures in 270 days and is purchased at $970.

To calculate the bank discount rate, divide the difference between the purchase price and par value by the par value.

($1,000 – $970)/$1,000 = 0.03, or 3%

Next, divide 360 days by the remaining days to maturity. Typically, a 360-day year is utilized for easier computation in determining the bank discount rate.

360/270 = 1.33

Multiply the aforementioned calculated figures to derive the bank discount rate.

3% x 1.33 = 3.99%

Hence, the bank discount rate in this scenario stands at 3.99%.

To recap the example above, the formula for computing the bank discount rate is:

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

Special Considerations

As the formula uses 360 days rather than 365 or 366 in a year, the bank discount rate calculated may be lower than the actual yield obtained on short-term money market investments. Consequently, this rate should not be considered an exact measure of the final yield received.