Bank Discount Rate: What it is, How it Works, Example

What Is the Bank Discount Rate?

The bank discount rate is the interest rate for short-term money market instruments like commercial paper and Treasury bills. The bank discount rate is based on the instrument's par value and the amount of the discount. The par value is the face value or original value of the investment when it was first issued. The bank discount rate is the required rate of return for a safe investment guaranteed by a bank.

Understanding the Bank Discount Rate

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.

Bank Discount Rate vs. Coupon Rate

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.

Example of Bank Discount Rate

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)

Special Considerations

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.