What Is a Discount Rate?
The discount rate is the interest rate the Federal Reserve charges commercial banksand other financial institutions for short-term loans. The discount rate is applied at the Fed's lending facility, which is called the discount window.
A discount rate can also refer to the interest rate used in discounted cash flow (DCF) analysis to determine the present valueof future cash flows.In this case, investors and businesses can use the discount rate for potential investments.
Key Takeaways
- In banking, the discount rate is the interest rate the Federal Reserve charges banks for short-term loans.
- Discount lending is a key monetary policy tool and part of the Fed's function as the lender-of-last-resort.
- In discounted cash flow analysis, the discount rate is the rate used to discount future cash flows.
- The discount rate expresses the time value of money in DCF and can make the difference between whether an investment project is financially viable or not.
- You can calculate the discount rate in DCF as long as you know the future and present values and the total number of years.
Fed's Discount Rate
How the Fed’s Discount Rate Works
Commercial banks in the U.S. have two primary ways to borrow money for their short-term operating needs. They can borrow and loan money to other banks without the need for any collateral using the market-driven interbank rate, or they can borrow money for their short-term operating requirements from the Federal Reserve Bank.
Federal Reserve loans are processed through the 12 regional branches of the Fed. The loans are used by financial institutes to cover any cash shortfalls, head off any liquidity problems, or in the worst-case scenario, prevent the bank’s failure. This Fed-offered lending facility is known as the discount window.
The loans are incredibly short-term: 24 hours or less. The rate of interest charged is the standard discount rate. The Board of Governors of the Federal Reserve set this discount rate.
The 3 Tiers of the Fed’s Discount Window Loans
The Fed's discount window program runs three tiers of loans, each using a separate but related rate. It also allows for emergency credit approvals for banks in distress.
The Fed determines the discount rates for the first two tiers independently. The rate for the third tier is based on the prevailing rates in the market.
- First Tier: Called the primary credit program, this tier provides capital to financially sound banks with good credit records. This primary credit discount rate is usually set above existing market interest rates which may be available from other banks or other sources of similar short-term debt.
- Second Tier: Called the secondary credit program, it offers similar loans to institutions that do not qualify for the primary rate. It is usually set 50 basis points higher than the primary rate (one percentage point = 100 basis points). Institutions in this tier are smaller and may not be as financially healthy as the ones that use the primary tier.
- Third Tier: Called the seasonal credit program, this one serves smaller financial institutions which experience higher seasonal variations in their cash flows. Many are regional banks that serve the needs of the agriculture and tourism sectors. Their businesses are considered relatively risky, so the interest rates they pay are higher.
- Emergency Credit: Banks applying for emergency credit must demonstrate proof that they cannot find a loan from another bank and requires a vote with the support of at least five members of the Board of Governors of the Federal Reserve.
All three types of the Federal Reserve's discount window loans are collateralized. The bank needs to maintain a certain level of security or collateral against the loan. Emergency credit may require collateral, but it's based on circ*mstances and the Fed's vote.
Use of the Fed’s Discount Rate
Borrowing institutions use this facility sparingly, mostly when they cannot find willing lenders in the marketplace. The Fed-offered discount rates are available at relatively high-interest rates compared to the interbank borrowing rates to discourage using the discount window too often.
The discount window is primarily intended as an emergency option for distressed banks—borrowing from it can even signal weakness to other market participants and investors.
Example of Fed Discount Rate
The use of the Fed's discount window soared in late 2007 and 2008 as financial conditions deteriorated sharply and the central bank took steps to inject liquidity intothe financial system.
In August 2007, the Board of Governors cut the primary discount rate from 6.25% to 5.75%, reducing the premium over the Fed funds rate from 1% to 0.5%. In October 2008, the month after Lehman Brothers' collapse, discount window borrowing peaked at $403.5 billion against the monthly average of $0.7 billionfrom 1959 to 2006.
Owing to the financial crisis, the board extended the lending period from overnight to 30 days, then to 90 days in March 2008. Once the economy recovered, those temporary measures were revoked, and the discount rate was reverted to overnight lending only.
The Fed maintains its own discount rate under the discount window program in the U.S. Most central banks across the globe use similar measures, although they vary by area. For instance, the European Central Bank (ECB) offers standing facilities that serve the same purpose. Financial organizations can obtain overnight liquidity from the central bank against the presentation of sufficient eligible assets as collateral.
Most commonly, the Fed's discount window loans are overnight only, but the loan period can be extended in periods of extreme economic distress, such as the 2008-2009 credit crisis.
How the Discount Rate Works in Cash Flow Analysis
The same term, discount rate, is used in discounted cash flow analysis. DCF is used to estimate the value of an investment based on its expected future cash flows. Based on the concept of the time value of money, DCF analysis helps assess theviability of a project or investment by calculating the present valueof expected future cash flows using adiscount rate.
Such an analysis begins with an estimate of the investment that a proposed project will require. Then, the future returns it is expected to generate are considered. Using the discount rate, it is possible to calculate the current value of any future cash flows. The project is considered viable if the net present value (PV) is positive. If it is negative, the project isn't worth the investment.
In this context of DCF analysis, the discount rate refers to the interest rate used to determine the present value. For example, $100 invested today in a savings scheme with a 10% interest rate will grow to $110. In other words, $110, which is the future value (FV), when discounted by the rate of 10%, is worth $100 (present value) as of today.
If one knows (or can reasonably predict) all such future cash flows (like the future value of $110), then, using a particular discount rate, the present value of such an investment can be obtained.
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What Is the Right Discount Rate to Use?
What is the appropriate discount rate to use for an investment or a business project? While investing in standard assets, like treasury bonds, the risk-free rate of return—generally considered the interest rate on the three-month Treasury bill—is often used as the discount rate.
On the other hand, if a business is assessing the viability of a potential project, theweighted average cost of capital (WACC) may be used as a discount rate. This is the average cost the company pays for capital from borrowing or selling equity.
In either case, the net present value of all cash flows should be positive if the investment or project is to get the green light.
Types of Discounted Cash Flow
There are different types of discount rates that apply to various investments of a business. What type is required depends on the needs and demands of investors and the company itself. Here are the most common:
- Cost of Debt: Companies must take on debt to finance their operations and keep the business running. The interest rate they pay on this debt is known as the cost of debt.
- Cost of Equity: The cost of equity is the rate corporations use to pay their shareholders. Investors expect a specific rate of return in exchange for taking on the risk of investing in a company.
- Hurdle Rate: The minimum rate of return on a certain investment or undertaking is known as the hurdle rate. This allows them to make important decisions on whether the venture is a good fit.
- Risk-Free Rate:The risk-free rate is the interest rate that comes with an investment or business venture with no risk.
- Weighted Average Cost of Capital: This is the rate of return that investors expect for their capital. Investors can include equity shareholders and bondholders.
Calculating the Discount Rate
To calculate the discount rate, use the following formula:
DR = ( FV ÷ PV ) 1/n - 1
Where:
- FV = Future value of cash flow
- PV = Present value
- (n) = Number of years until the FV
Here's an example to show how the discount rate works. Let's say you want to determine the discount rate on a certain investment using the following variables:
| Future Value | $5,000 |
| Present Value | $3,500 |
| Number of Years | 10 |
Now, let's use the formula above to determine the discount rate. For the fractional exponent, you can convert it to a decimal ( 1 ÷ 10 ):
DR = ( FV ÷ PV ) 1/n - 1
DR = ( $5,000 ÷ $3,500 ) 1/10 - 1
DR = $1.42857 0.1 - 1
DR = 1.03631 - 1
DR = 0.03631
So, in this case, the discount rate is 3.631%.
What Effect Does a Higher Discount Rate Have on the Time Value of Money?
The discount rate reduces future cash flows, so the higher the discount rate, the lower the present value of the future cash flows. A lower discount rate leads to a higher present value. As this implies, when the discount rate is higher, money in the future will be worth less than it is today—meaning it will have less purchasing power.
How Is Discounted Cash Flow Calculated?
There are three steps to calculating the DCF of an investment:
- Forecast the expected cash flows from the investment.
- Select an appropriate discount rate.
- Discount the forecasted cash flows back to the present using a financial calculator, a spreadsheet, or a manual calculation.
How Do You Choose the Appropriate Discount Rate?
The discount rate used depends on the type of analysis undertaken. When considering an investment, the investor should use the opportunity cost of putting their money to work elsewhere as an appropriate discount rate. That is the rate of return that the investor could earn in the marketplace on an investment of comparable size and risk.
A business can choose the most appropriate of several discount rates. This might be an opportunity cost-based discount rate, its weighted average cost of capital, or the historical average returns of a similar project. In some cases, using the risk-free rate may be most appropriate.
The Bottom Line
The discount rate is the lending rate at the Federal Reserve's discount window, where banks can get a loan if they can't secure funding from another bank on the market. A discount rate is also calculated to make business or investing decisions using the discounted cash flow model.
Article Sources
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Federal Reserve. "The Discount Window."
Federal Reserve History. "Federal Reserve Credit Programs During the Meltdown."
European Central Bank. "What Is the Marginal Lending Facility Rate?"
