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Discount rate
 
 
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The discount rate is an interest rate a central bank charges depository institution
Depository institution

A depository institution is a financial institution in United States, such as a savings bank, that is legally allowed to accept monetary deposits from consumers....
s that borrow reserves from it.

The term discount rate has two meanings:





annual effective discount rate is the annual interest divided by the capital including that interest, which is the interest rate divided by 100% plus the interest rate. It is the annual discount factor to be applied to the future cash flow, to find the discount, subtracted from a future value to find the value one year earlier.

For example, suppose there is a government bond
Government bond

A government bond is a Bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds....
 that sells for $95 and pays $100 in a year's time.






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Encyclopedia


The discount rate is an interest rate a central bank charges depository institution
Depository institution

A depository institution is a financial institution in United States, such as a savings bank, that is legally allowed to accept monetary deposits from consumers....
s that borrow reserves from it.

The term discount rate has two meanings:

  • the same as interest rate
    Interest rate

    An interest rate is the price a borrower pays for the use of money they do not own, for instance a small company might borrow from a bank to kick start their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower....
    ; the term "discount" does not refer to the meaning of the word, but to the purpose of using the quantity, such as computations of present value
    Present value

    Present value is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk....
    , e.g. net present value
    Net present value

    Net present value or net present worth is defined as the total present value of a time series of cash flows. It is a standard method for using the time value of money to appraise long-term projects....
     / discounted cash flow
    Discounted cash flow

    In finance, the discounted cash flow approach describes a method of valuing a project, company, or financial asset using the concepts of the time value of money....


  • the annual effective discount rate, which is the annual interest divided by the capital including that interest; this rate is lower than the interest rate; it corresponds to using the value after a year as the nominal value, and seeing the initial value as the nominal value minus a discount
    Discount

    A "Discount" is a "Charge" that is paid to obtain the right to delay a payment. Essentially, the payer purchases the right to make a given payment in the future instead of in the Present....
    ; it is used for Treasury Bills and similar financial instruments


Annual effective discount rate

The annual effective discount rate is the annual interest divided by the capital including that interest, which is the interest rate divided by 100% plus the interest rate. It is the annual discount factor to be applied to the future cash flow, to find the discount, subtracted from a future value to find the value one year earlier.

For example, suppose there is a government bond
Government bond

A government bond is a Bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds....
 that sells for $95 and pays $100 in a year's time. The discount rate according the given definition is

The interest rate is calculated using 95 as its base:

For every annual effective interest rate
Effective interest rate

The effective interest rate, effective annual interest rate, Annual Equivalent Rate or simply effective rate is the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest....
, there is a corresponding annual effective discount rate, given by the following formula:

or inversely,

where the approximations apply for small i and d; in fact i - d = id.

See also notation of interest rates
Actuarial notation

Actuarial notation is a shorthand method to allow Actuary to record mathematical formulas that deal with Interest and life tables.Traditional notation uses a halo system where symbols are placed as superscript or subscript before or after the main letter....
.

Business calculations


Businesses need to consider the discount rate when deciding whether to spend some of their profits on buying a new piece of equipment, or whether to give the profit back to their shareholders. In an ideal world, they would only buy a piece of equipment if the shareholders would get a bigger profit later. The amount of extra profit that a shareholder requires in the future in order to prefer that the company buy the equipment rather than giving them the profit now is based on the shareholder's discount rate. There is a widely used way of estimating shareholder's discount rates using share price data. It is known as the capital asset pricing model
Capital asset pricing model

In finance, the Capital Asset Pricing Model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified Portfolio , given that asset's non-Diversification risk....
. Businesses normally apply this discount rate to their decisions about purchasing equipment by calculating the net present value
Net present value

Net present value or net present worth is defined as the total present value of a time series of cash flows. It is a standard method for using the time value of money to appraise long-term projects....
 of the decision.

See also

  • Discount window
    Discount window

    The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions....
  • Discount
    Discount

    A "Discount" is a "Charge" that is paid to obtain the right to delay a payment. Essentially, the payer purchases the right to make a given payment in the future instead of in the Present....
  • Social discount rate
    Social discount rate

    Social Discount Rate is a measure used to help guide choices about the value of diverting funds to social projects. It is defined as ?the appropriate value of r to use in computing present discount value for social investments? ....
  • Ramsey growth model
    Ramsey growth model

    The Ramsey growth model is a neo-classical model of economic growth based primarily on the work of the economist and mathematician Frank P. Ramsey....
  • compare and contrast with Fed Funds


External links

  • from the Finance and Banking Dictionary