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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 ratethe 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 ratethe 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.
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.