What is the Discount Rate?
Depending upon the context, discount rate has two different definitions and usages. First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal Reserve Bank through the discount window loan process, and second, the discount rate refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.
Discount Rate for Fed’s Discount Window Loans
While commercial banks are free to borrow and loan capital among each other using the market-driven interbank rate without the need of any collateral, they can also borrow the money for their short term operating requirements from the Federal Reserve Bank. Such loans are served by the 12 regional branches of the Fed, and the loaned capital is used by the financial institutes to fulfill for any funding shortfalls, to prevent any potential liquidity problems or, in the worst-case scenario, to prevent a bank’s failure. This special Fed-offered lending facility is known as the discount window. Such loans are granted by the regulatory agency for an ultra-short term period of 24-hours or less (like, overnight), and the applicable rate of interest charged on these loans is a standard discount rate. This discount rate is not a market rate, rather it is administered and set by the boards of the Federal Reserve Bank and is approved by its Board of Governors.
Fed's discount window program runs three different tiers of loans, and each of them uses a separate but related rate. The first tier, called the primary credit program, is focused on offering required capital to the “financially-sound” banks that have a good credit record. This primary credit discount rate is usually set above the existing market interest rates which may be available from other banks or from other sources of similar short term debt. The next tier, called the secondary credit program, offers similar loans to institutions that do not qualify for the primary rate and is usually set 50 basis points higher than the primary rate ( 1 percentage point = 100 basis points). Institutions in this tier are smaller than and may not be as financially healthy as the ones in the primary tier which accounts for the higher discount rate charged to the loans offered to them by the Fed. The third tier, called the seasonal credit program, serves the smaller financial institutions which have higher variance in their cash flows, though the cash flows may be predictable to a good extent.
For instance, financial institutes associated with agriculture or tourism sector may have fluctuations in their cash flows owing to seasonal patterns, but depending on the weather conditions they remain predictable. However, institutions in this tier are the riskiest and the rates charged to them are also higher.
While the discount rates for the first two tiers are determined independently by the Fed and the rate determination process does not take into account any market-based inputs, the discount rate for the third tier is determined based on the prevailing rates in the market. Typically, an average of select set of market rates of comparable alternative lending facilities is taken into account while arriving at the seasonal credit program discount rate.
All the three types of discount window loans are collateralized, that is – the borrower needs to maintain certain security or collateral against the loan.
Use of Fed’s Discount Rate
Since the Fed-offered discount rates are available at relatively higher interest rates as compared to the interbank borrowing rates, the borrowing institutions use this facility sparingly. Its use peaks during the periods of financial distress.
For instance, 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 into the financial system. In August 2007, the Board of Governors cut the primary discount rate from 6.25 percent to 5.75 percent, reducing the spread over the fed funds rate from 1 percentage point 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 billion from 1959 to 2006. Owing to the financial crisis, the board also extended the lending period from overnight to 30 days, and then to 90 days in March 2008. Once the situation came back in control, those temporary measures were revoked and the discount rate was reverted to the overnight lending only.
While Fed maintains its own discount rate under the discount window program in the U.S., other central banks across the globe also use similar measures in different variants. For instance, the European Central Bank offers standing facilities which serves as a marginal lending facility through which financial organizations can obtain overnight liquidity from the central bank against the presentation of sufficient eligible assets as collateral.
Discounted Cash Flow Analysis
The second use of discount rate is in the discounted cash flow analysis. DCF is a commonly followed valuation method used to estimate the value of an investment based on its expected future cash flows. Based on the concept of time value of money, the DCF analysis helps assess the viability of a project or an investment by calculating the present value of expected future cash flows using a discount rate. In simple terms, if a project needs a certain investment now (as well as in future months) and predictions are available about the future returns it will generate, then using the discount rate it is possible to calculate the current value of all such cash flows. If the net present value is positive, the project is considered viable, else financially unfeasible.
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 that offers 10 percent interest rate will grow to $110. Put another way, $110 (future value) when discounted by the rate of 10 percent is worth $100 (present value) as of today. If one knows (or can reasonably predict) all such future cash flows (like future value of $110), then using a particular discount rate the future value of such an investment can be obtained.
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 is often used as the discount rate. On the other hand, if a business is assessing the viability of a potential project, they may use the weighted average cost of capital (WACC) as a discount rate, which 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 to proceed with the investment or the project.
The discount rate can also refer to the rate at which pension plans and insurance companies discount their liabilities.