What Is a Discount Rate?
Depending upon the context, the discount rate has two distinct definitions and usages.
- The discount rate is the interest rate charged to commercial banks and other financial institutions for short-term loans they take from the Federal Reserve Bank.
- The discount rate refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.
- The term discount rate can refer to either the interest rate that the Federal Reserve charges banks for short-term loans or the rate used to discount future cash flows in discounted cash flow (DCF) analysis.
- In a banking context, discount lending is a key tool of monetary policy and part of the Fed's function as the lender-of-last-resort.
- In discounted cash flow analysis, the discount rate expresses the time value of money and can make the difference between whether an investment project is financially viable or not.
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. They also can borrow the money for their short-term operating requirements from the Federal Reserve Bank.
Federal Reserve loans are processed through 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 extremely short-term: 24 hours or less. The rate of interest charged is the standard discount rate. This discount rate is set by the boards of the Federal Reserve Bank and is approved by its Board of Governors.
Fed's Discount Rate
The Three Tiers of the Fed’s Discount Window Loans
The Fed's discount window program runs three tiers of loans, each of them using a separate but related rate.
- The first tier, called the primary credit program, provides capital to financially sound banks that have a good credit record. This primary credit discount rate is usually set above 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. It is usually set 50 basis points higher than the primary rate (1 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.
- The third tier, called the seasonal credit program, 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.
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.
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.
Discount loans are intended to be primarily an emergency option for banks in distress. Borrowing from the Fed discount window can even signal weakness to other market participants and investors.
Its use peaks during periods of financial distress.
Fed Discount Rate Example
The use of the Fed's discount window soared in late 2007 and in 2008, as financial conditions deteriorated sharply and the central bank took steps to inject liquidity into the financial system.
The discount rates for the first two tiers are determined independently by the Fed. The rate for the third tier is based on the prevailing rates in the market.
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 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 economy regained control, those temporary measures were revoked, and the discount rate was reverted to overnight lending only.
Outside the U.S.
While the 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 that serve as marginal lending facilities. 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 in periods of extreme economic distress, such as the 2008-2009 credit crisis, the loan period can be extended.
How the Discount Rate Works in Cash Flow Analysis
The same term, discount rate, is used in discounted cash flow (DCF) 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 the viability of a project or investment by calculating the present value of expected future cash flows using a discount 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 all such future cash flows. If the net present value is positive, the project is considered viable. 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 that offers a 10% interest rate will grow to $110. In other words, $110 (future value) 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.
Discounting With The Discount Rate
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 is often used as the discount rate.
On the other hand, if a business is assessing the viability of a potential project, the weighted 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.
What Effect Does a Higher Discount Rate Have on the Time Value of Money?
Future cash flows are reduced by the discount rate, 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. 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 day, using a financial calculator, a spreadsheet, or a manual calculation.
How Do You Choose the Appropriate Discount Rate?
The discount rate used will depend 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, or its weighted average cost of capital (WACC), or the historical average returns of a similar project. In some cases using the risk-free rate may be most appropriate.