What is a Bank Discount Rate?

The bank discount rate refers to the interest rate that the Central bank or Federal Reserve charges for short-term loans issued to commercial banks and financial institutions. Usually, when a bank is short funds, it can take a loan from other banks or from the Federal Reserve. The bank discount rate is also the interest rate charged for short-term financial instruments such as Treasury bills, and commercial papers. When a change occurs in the bank discount rate charged by the Z central bank or Federal Reserve, the interest rate charged by commercial banks and other institutions in the money market would also change.

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How Does a Bank Discount Rate Work?

To calculate the bank discount rate, the formula below is applicable; Bank Discount Rate = (Dollar Discount/Face Value) x (360/Time to Maturity) It is important to know that the recognizable days of a year in this formula is 360 days as against the 365 or 366 days of a year. This means that the bank discount rate, when calculated, gives a lower return than the actual yield investors earn on short-term money market investments. In investment, the bank discount rate is also used to calculate the interest that investors receive on non-coupon discount investments.