Discount rate

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1. Cost of capital.

'Discount rate' is often used as a synonym for the cost of capital.

In this context, discount rate is the generic name for the rate of interest at which the future cash flows of a proposed investment are discounted, in order to obtain the net present value of the cash flows.

The choice of discount rate should reflect the risks of the investment or project.

2. Short-term markets.

In short-term financial markets, 'discount rate' means the quoted market rate for traded instruments quoted at a discount.

The market discount rate is quoted based on a percentage of the maturity amount.

Example 1: Discount rate calculation

The maturity amount for an investment is £10m.

The gain for the single period from the start to the final maturity is £2m.

The periodic discount rate (d) is:

(d) = Gain / End amount

= 2 / 10

= 20%

In the US the market, discount rate is sometimes known as the discount yield.

This is different from a yield or interest rate, which is conventionally quoted based on a percentage of the starting amount.

Example 2: Yield calculation

The starting amount for an investment is £8m.

The gain for the single period from the start to the final maturity is £2m.

The periodic yield (r) is:

(r) = Gain / Start amount

= 2 / 8

= 25%

Notice that the discount rate and the yield calculated above both relate to exactly the same deal.

£8m is invested now, and £10m is repaid at the end of one period.

The discount rate of 20% and the yield of 25% both summarise the same deal, using different conventional bases.

3. Pensions.

In the field of pensions, discount rate means the rate used to discount future liabilities of a Defined benefit pension scheme in order to calculate the present value of the liabilities, often for the purpose of comparing them with the market value of the scheme’s assets.

Historically it was common to use the blended rate of investment return expected on the actual assets in the scheme, but typically now a market rate is used, such as the government bond or AA corporate bond yield for a fixed income security with a similar duration to that of the underlying liabilities.

4. Central banking.

In US central banking, the term 'discount rate' means the interest rate that member banks pay the Federal Reserve when the banks use securities as collateral.

The discount rate acts as a benchmark for interest rates issued.

Other central banks also have similar discount rates.

See also

Other resource

Students: Triumph with timelines, The Treasurer, March 2013