Bank Discount Rate Explained: How It Functions and Its Importance

What Is the Bank Discount Rate?

The bank discount rate is a method for calculating the interest rate on short-term money market instruments, such as Treasury bills and commercial paper, based on their par value and discount amount. Investors use the bank discount rate to estimate the interest they earn, thereby assessing the return on safe, short-term investments. Understanding this rate is crucial for accurately evaluating investment returns and making informed financial decisions in the money market.

How the Bank Discount Rate Works

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.

Comparing Bank Discount and Coupon Rates

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.

Bank Discount Rate Calculation Example

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)

Important Factors in Bank Discount Rate Calculations

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.