Information about Discount Rate

For the interest rate charged to banks for borrowing short term funds directly from a central bank, see discount window.

The discount rate is a financial concept based on the future cash flow in lieu of the present value of the cash flow. The divisor in the discount rate formula is the resultant future value, including income.

The concept of a discount rate differs from that of an interest rate, most notably in that the divisor in the interest rate formula is the original investment.

Example

Suppose there is a government bond that sells for $80 and pays $100 in a year's time. The discount rate represents the discount on the future cash flow:

The interest rate on the cash flow is calculated using 80 as its base:

For every interest rate, there is a corresponding discount rate, given by the following formula:

An alternative method of understanding a discount rate is to consider that the discount rate tells how much future value is interest and how much is principal. For example, if $100 is deposited into an account that pays 50% interest, the amount that is subsequently withdrawn will be $150. The discount rate is 0.5/(1+0.5) = 1/3 or 33.3%. Based on this, 33.3% of the $150 is interest and the other 66.7% is principal.

The interest rate that is used to calculate the Internal rate of return or Net present value of investments is NOT the discount rate as defined here. Similarly Discounted cash flow uses the normal calculation of interest, not the discount rate defined here.

Economic Policy

One of the major issues in economics is what is an appropriate discount rate to use under various circumstances. For example, in assessing the impact of very long-term phenomena such as climate-change, use of any discount rate much more than 1% per annum renders long-term damage (occurring in, say, 200 years time) of negligible importance now, and therefore entails that there is no need to take preventative action. However, discount rates for climate change are uncertain and debatable in today's economic and scientific community.

Conversely, governments often take a short-term view of things, effectively applying discount rates of perhaps 20% p.a. or higher, on the grounds that anything they do or fail to do which has detrimental effects in (say) 10 or more years' time won't prevent their re-election sooner than that.

In practice, discount rates such as 2%, 3%, 5% and 10% are widely used in economics. However there is little consensus on what value is appropriate in any given circumstance, and it often makes a significant difference.

See also

• Discount window
• Discount

External links

• Definition of the "Discount Rate" from the Federal Reserve Board's official site
• Instruments of the Money Market: Table of Contents
• The Discount Rate and Theories of the Great Depression, R. L. Norman, Jr.
• Instruments of the Money Market: Chapter 3 - The discount window

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