What is the discount rate? Definition and meaning
The discount rate can mean: 1. The interest rate that the Federal Reserve in the United States charges on loans given to banks through its discount window loan process. 2. The rate by which the amount on an invoice is reduced when a condition is met, or when an order amount is greater than a certain minimum figure. 3. The interest rate used in discounted cash flow analysis to determine the current value of future cash flows. 4. The rate at which an accounts receivable or bill of exchange is paid (discounted) before its maturity date.
The term may also apply to the fees charged to merchants for accepting credit cards.
The bank rate, base rate, and federal discount rate all have the same or very similar meanings to the discount rate.
The Federal Reserve System’s discount rate refers to three credit programs.
Federal Reserve System discount rate
The discount window allows financial institutions to borrow money for short-term – 24 hours or less – operating needs.
Each of the Federal Reserve banks determine the interest rate – this is reviewed and also determined by the Federal Reserve System’s Board of Governors.
The discount rate is generally the same across all the twelve Federal Reserve Banks, except for the period around the time the discount rate is changed.
The twelve federal reserve banks are: Federal Reserve Bank of Boston, Federal Reserve Bank of San Francisco, Federal Reserve Bank of New York, Federal Reserve Bank of Dallas, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Richmond, Federal Reserve Bank of Atlanta, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Minneapolis, and Federal Reserve Bank of Chicago.
With a discounted bill of exchange, you cash it in with your bank before the maturity date. The bank pays you at a discount – minus the interest lost due to early cashing in. The bank presents the bill at maturity and gets paid. If it does not get paid at maturity, you are liable for that amount.
The discount window offers three loan programs, each one with its own discount rate:
– Primary Credit: the Feds main lending program for eligible financial institutions in ‘generally sound financial condition’.
– Secondary Credit: designed for financial institutions that are not eligible for the primary program, but still need very short-term loans to resolve severe financial difficulty or fund short-term requirements. These loans carry a slightly higher discount rate.
– Seasonal Credit: for smaller financial institutions that have recurring cash flow fluctuations.
According to the Board of Governors of the Federal Reserve System in the United States:
“The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility–the discount window.”
Discounted cash flow analysis
The discount rate in discounted cash flow analysis (DCF) takes into account both the time value of money and also the risk or uncertainty of future cash flows plus the effects of inflation.
The discount rate rises according to the level of uncertainty of future cash flow. It is an equation that tells us how much a series of future cash flows is worth as a single lump sum value now.
This calculations is extremely useful for investors who wish to value businesses or other investments with predictable cash flow and profits.
Imagine a fictitious company called John Doe Inc., a large blue-chip company that was founded over a century ago – it has considerable and consistent market share. While John Doe is consistently profitable, it does not have the opportunity of faster growth. This stable, consistent and predictable company is a prime candidate for a DCF analysis.
If we can predict John Doe’s future earnings, we can use the discounted cash flow to determine what its valuation should be today. There is more to it than just adding up the cash flow figures and coming to a value. This is where the discount rate comes onto the scene.
Cash flow tomorrow is worth less than cash flow today, mainly because of inflation and unexpected events. No future projection can be guaranteed to be 100% accurate – simply, because we just don’t know what will happen, including an unexpected decline in John Doe’s earnings.
Cash flow today, on the other hand, is what it is – it has no such uncertainty. We must discount future cash flow, given that any future forecast carries a risk, to compensate for the risk we take in waiting for it to come.
These two factors – the uncertainty risk and money’s time value – together form the theoretical basis for the discount rate. The greater the uncertainty the higher the discount rate will be, and the lower the current value of our future cash flow.
According to ft.com/lexicon, the discount rate is:
“The interest rate charged by a central bank to commercial banks when lending short-term funds (by discounting government paper or using government paper as collateral). In the US, the discount rate, which acts as a reference rate for commercial banks’ own lending rates, is one of the two key rates manipulated by the Federal Reserve to control money supply (the other being the Federal funds rate).”
“The discount rate is also the interest rate at which commercial banks discount bills of exchange. The term also refers to the interest rate used to calculate discounted cash flow.”
Discounted bill of exchange
Discount may also refer to an accepted draft or bill of exchange that is sold to a bank or credit institution for early payment at less than face value after the bank deducts applicable interest charges and fees.
The credit institution or bank then collects the bill of exchange’s or draft’s full value when payment comes due.
For example, imagine you have a bill for $10,000 and you discount this bill with your bank two months before its due date at 15% p.a. rate of discount. The discount will be calculated in the following way:
1,000 × 15/100 × 2/12 = 250
So, you will receive $9,750 in cash and bear a loss of $250. The bank will hold onto this bill until the due date and present it to the acceptor who – if the bill is honored – will pay the $10,000 to the bank.
If the bill is not honored, you will be liable, i.e. you will have to pay the cash to the bank.
Video – Fed Discount Rate
This Financial IQ Solutions video describes how the US Federal Reserve System uses the Discount Rate as a monetary policy tool to stabilize the economy.