DEFINITION of 'Pure Discount Instrument'

A pure discount instrument is a type of security that pays no income until maturity; upon expiration, the holder receives the face value of the instrument. The instrument is originally sold for less than its face value (at a discount) and redeemed at par.

BREAKING DOWN 'Pure Discount Instrument'

Some debt instruments require the issuer to repay the lender the amount borrowed plus interest. This entails making periodic interest payments to the lender until the security matures, at which point the lender is repaid the face value of the security. In other cases, the securities do not make scheduled interest payments. Instead, investors can purchase the securities at a value less than par and receive the face value at maturity. These securities are referred to as pure discount instruments.

Pure discount instruments can take the form of zero-coupon bonds or Treasury bills. The discount on these securities, that is, the difference between the purchase price and the redemption value at maturity, represents the interest that accumulates on these debt instruments. If a pure discount instrument is held to maturity, the bondholder will earn a dollar return equal to the discount. For example, let's assume a Treasury bill with a face value of $1,000 has a time to maturity of 270 days and is currently selling for $950. If the investor holds the T-bill until it matures, she will earn a positive yield of:

r = (Discount / Face value) x (360 / t)

where r = annualized yield

Discount = Face value – Purchase price

360 = bank convention on the number of days per year

t = time to maturity

Following our example above, the yield can be calculated as

r = ($50/$1,000) x (360 / 270)

= 0.05 x 1.33

= 0.0665, or 6.65%.

The formula used above is referred to as the bank discount yield.

The yield on pure discount instruments is the annualized return that results when the bonds are converted to face value. This yield is also referred to as the spot interest rate. An interest-bearing bond with predictable cash flows or interest payments can be seen as a portfolio of pure discount bonds. Coupon-bearing bonds are priced using spot rates by assigning:- the yield of a pure discount instrument maturing in six months to the coupon payment six months from now, the yield of a one-year pure discount instrument to the coupon payments one year from now, and so on, until yields have been assigned to all the bond’s cash flows. The formula for this calculation is:

Price = C1/(1+r1) + C2/(1+r2)2 + C3/(1+r3)3 + … + Cn/(1+rn)n + F/(1+rn)n

Where C = the cash flow for period n

r = spot rate of interest for period n

F = face vale at maturity

As long as pure discount instruments are available at all maturity terms, the spot rates will accurately reflect the term structure of interest rates.

  1. Discount Note

    A discount note is a short-term debt obligation issued at a discount ...
  2. Discounting

    Discounting is the process of determining the present value of ...
  3. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  4. Market Discount

    The market discount is the difference between a bond's stated ...
  5. Current Yield

    Current yield is the annual income (interest or dividends) divided ...
  6. Bond Discount

    Bond discount is the amount by which the market price of a bond ...
Related Articles
  1. Investing

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  2. Investing

    4 basic things to know about bonds

    Learn the basic lingo of bonds to unveil familiar market dynamics and open to the door to becoming a competent bond investor.
  3. Investing

    Debt Buybacks Continue

    Many companies are buying bonds back at a discount, and adjusting capital structures to more acceptable levels.
  4. Investing

    Understanding Interest Rates, Inflation And Bonds

    Get to know the relationships that determine a bond's price and its payout.
  5. Investing

    How to compare the yields of different bonds

    Understand how to compare the yields of different bonds and find out how to equalize and compare fixed-income investments with different yield conventions.
  6. Insurance

    Get Sale Prices On Healthcare With Discount Plans

    Medical discount plans can help the uninsured or underinsured afford better healthcare.
  7. Investing

    Texas Instruments Trades Ex-Dividend Thursday

    Texas Instruments will send its dividend payment on May 15 to shareholders of record as of May 1.
  8. Investing

    What Is A Municipal Bond?

    A municipal bond is a debt instrument used by a city, state, county or other local government authority to raise money for a project. Municipal bonds, often called munis, are considered a debt ...
  9. Investing

    Find the Right Bond at the Right Time

    Learn about the types of bonds you should consider investing in, when you should be buying them and how to compare yields against their time to maturity.
  1. When is a bond's coupon rate and yield to maturity the same?

    Find out when a bond's yield to maturity is equal to its coupon rate, and learn about the components of bonds and how they ... Read Answer >>
  2. How do I calculate yield to maturity of a zero-coupon bond?

    Find out how to calculate the yield to maturity of a zero-coupon bond, and learn why this calculation is simpler than one ... Read Answer >>
  3. Learn to Calculate Yield to Maturity in MS Excel

    Find out the best practices for most financial modeling to price a bonds, calculate coupon payments, then learn how to calculate ... Read Answer >>
  4. Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... Read Answer >>
Trading Center