Discount rate

The interest rate that the Federal Reserve charges a bank to borrow funds when a bank is temporarily short of funds. Collateral is necessary to borrow, and such borrowing is quite limited because the Fed views it as a privilege to be used to meet short-term liquidity needs, and not a device to increase earnings. In context of NPV or PV calculations, the discount rate is the annual percentage applied. In the context of project financing, the discount rate is often the all-in interest rate or the interest rate plus margin.

Discount Rate

The interest rate at which the Federal Reserve makes short-term loans to member banks. The discount rate is an indicator of the direction in which the Federal Reserve is trying to push the broader economy. In general, a low interest rate indicates that it is trying to promote growth by making liquidity easily available, and a high interest rate shows that the Fed is concerned about inflationary pressures on the economy and trying to reduce the amount of money in the economy. Along with the sale of Treasury securities and the determining of the fed funds rate, setting the discount rate is one of the primary ways the Federal Reserve sets the monetary policy of the United States.

discount rate

1. The interest rate charged by the Federal Reserve on loans to its member banks. A change in this rate is viewed as a strong indicator of Fed policy with respect to future changes in the money supply and market interest rates. Generally, a rise in the discount rate signals increasing interest rates in the money and capital markets.

2. The rate at which an investment's revenues and costs are discounted in order to calculate its present value.

Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved. All rights reserved.

Discount rate.

The discount rate is the interest rate the Federal Reserve charges on loans it makes to banks and other financial institutions.

The discount rate becomes the base interest rate for most consumer borrowing as well. That's because a bank generally uses the discount rate as a benchmark for the interest it charges on the loans it makes.

For example, when the discount rate increases, the interest rate that lenders charge on home mortgages and other loans increases. And when the discount rate is lowered, the cost of consumer borrowing eventually decreases as well.

The term discount rate also applies to discounted instruments like US Treasury bills. In this case, the rate is used to identify the interest you will earn if you purchase at issue, hold the bill to maturity, and receive face value at maturity.

The interest is the difference between what you pay to purchase the bills and the amount you are repaid.

discount rate

the INTEREST RATE at which future cash inflows and cash outflows associated with an INVESTMENT project are discounted in order to allow for the timing of these cash flows. The discount rate used by firms in evaluating the desirability of investments is frequently based upon the average COST OF CAPITAL to the firm. See DISCOUNTED CASH FLOW.

discount rate

the INTEREST RATE at which the streams of cash inflows and outflows associated with an INVESTMENT project are to be discounted. For private-sector projects, the discount rate is frequently based upon the weighted-average COST OF CAPITAL to the firm, with the interest cost of each form of finance (long-term loans, overdrafts, equity etc.) being weighted by the proportion that each form of finance contributes to total company finances.

The discount rate for public-sector investment projects involves more complex considerations. It can be argued that, while individuals have a limited lifespan and so will not look too many years ahead for returns on investment, society continues indefinitely as some individuals die and are replaced by others being born, so society will tend to look further ahead for returns. This disparity between private time preference and social time preference means that society will tend to discount the future less heavily than the individual and would favour a lower discount rate. On the other hand, opportunity-cost considerations may make it difficult for society to apply a lower, less stringent, discount rate to public sector projects than is applied in the private sector. Otherwise, inferior projects in the public sector could divert funds away from superior projects in the private sector. The social opportunity-cost discount rate may well therefore need to be similar to the private sector rate. Finally, the government borrowing rate is a risk-free interest rate since it entails little risk of default in repaying the loan, while private sector rates entail a risk premium, so that the government borrowing rate may be too low in opportunity-cost terms.

In most public investment appraisals the discount rate applied has tended to follow current prevailing private-sector interest rates. See INVESTMENT APPRAISAL, DISCOUNTED CASH FLOW, PAYBACK PERIOD, COST-BENEFIT ANALYSIS, TIME PREFERENCE.

discount rate

The rate at which the Federal Reserve loans money to lenders to cover short-term cash needs, usually for overnight loans. Increases or decreases in the discount rate almost always signal similar increases or decreases in bank loan rates to customers, even though the two are not directly tied to each other.