What is a Discount Rate?

The term discount rate refers to two very discreet concepts in finance. First, the discount rate refers to the interest rate paid by the commercial banks and other depository financial houses against a loan received from the regional Federal Reserve Banks lending facility. Second, when doing a discounted cash flow analysis, the discount rate refers to the interest rate used for calculating the present value of future cash flows.

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How Does a Discount Rate Work?

Discount rates are offered to financial institutions to prevent bank failure or liquidation. It is a very short-term loan granted by the Federal Reserve Banks 12 regional branches in cases of fund crunches.

• Note: the banks having deposits in the Federal Reserve Bank System can perform interbank borrowing administered by the federal funds rate. The discount rate is different than interbank borrowing.

There are three different discount window programs for depository institutions:

• primary credit - Primary credit programs are for the depository institutions with a sound financial condition. The loans under this program are granted for a very short term, typically overnight. It is offered to the banks and institutions with good credit rate. It is Federal Reserves main discount window program. Sometimes it is simply called the discount rate. The discount rate payable for this program is above the usual level of the short-term interest rate of the market.
• secondary credit - Secondary credit is for the banks with severe financial crisis or liquidity issues who do not qualify for the primary credit. The discount rate in this program is above the rate of primary credit.
• seasonal credit - Seasonal credit is offered to the smaller depository institutions having repeated intra-year fluctuation in the need of funds. The rate is an average of selected market rates. Banks serving the agricultural communities or seasonal resort communities are generally the ones getting seasonal credit.

Each of these windows has their own interest rate. The boards of Federal Reserve Banks determine the discount rate, and the Board of Governors approves the rate. All the branches of the Reserve Bank offer the same rate for these programs except on the days when there is a change in the rate.

Discounted Cash Flow Analysis

In discounted cash flow analysis, the interest rate used for computing the present value of cash flow is called the discount rate. It is a useful tool for investors to find out the potential value of a company of investment with an expected future cash flow. For example, if the discount rate is 10% the present value of $1,000 from one year now would be $1000/ (1+0.1)^1 = $909.09. In two years, it would be $1000/(1+0.1)^2 = $826.45.

• Note: The pension plans and insurance companies discount rate of their liabilities are also called the discount rate.

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