Discount rate
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The term discount rate is used in several different contexts:
Credit cards
The discount rate is a percentage of the dollar amount of the transaction that a merchant is charged for each credit card transaction.
Mathematical Discount Rate
Discount rate normally refers to the interest rate, though in fact a discount rate is slightly different from the interest rate, in terms of how it is calculated. This is because the discount rate is based on the future cash flow in lieu of the present value of the cash flow.Assume I have $80, and I buy a government bond that pays me $100 in a year's time. The discount rate represents the discount on the future cash flow:
(100-80)/100 = 20%The interest rate on the cash flow is calculated using 80 as its base:
(100-80)/80 = 25%It should become apparent that for every interest rate, there is a corresponding discount rate, given by the following formula:
d = i/(1+i)Again when referring to a cash flow being discounted, it will likely refer to the interest rate and not the proper mathematical discount rate. However, the two are separate concepts in financial mathematics.
Monetary Policy
The discount rate is the interest rate that an eligible depository institution (such as a bank) is charged to borrow short term funds directly from the central bank through the discount window. This is also known as the base rate, repo rate and/or primary rate, as a profit-making bank will need to charge rates higher than this to its customers.Project Valuation
The discount rate is the value used in accounting procedures to determine the present value of future cash flows arising from a project, ie the discounted value of all future cashflows. Where [r_n] is the interest rate.Typically, the discount rate is arrived at by beginning with the appropriate interest rate 8-12% for the length of time in question, then adding an additional sum to account for risk. Normally, investors add 15% to term-specific risk-free rates and another 10 till 15% for start-up projects. Discount rates of 25% till 40% are thus very common, especially for start-up projects.
As such, the discount rate used will almost always vary from project to project, and will likely vary for cash flows of different maturities when valuing the same project.
Economics
One of the major issues in economics is what is an appropriate discount rate to use under various circumstances. For example, in assessing the impact of very long-term phenomena such as climate change, use of any discount rate much more than 1% per annum renders long-term damage (occurring in, say, 200 years time) of negligible importance now, and therefore entails (implausibly) that there is no need to take preventative action.Conversely, governments often take a short-term view of things, effectively applying discount rates of perhaps 20% p.a. or higher, on the grounds that anything they do or fail to do which has detrimental effects in (say) 10 or more years' time won't prevent their re-election sooner than that.
In practice, discount rates such as 2%, 3%, 5% and 10% are widely used in economics. However there is little consensus on what value is appropriate in any given circumstance, and it often makes a significant difference.
External links
- [Instruments of the Money Market: Table of Contents]
- *[Instruments of the Money Market: Chapter 3 - The discount window]
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