What is the ‘Discount Rate’
The discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve’s discount window.
The discount rate also refers to the interest rate used in discounted cash flow analysis to determine the present value of future cash flows.
BREAKING DOWN ‘Discount Rate’
The Fed’s discount rate is an administered rate set by the boards of the Federal Reserve Banks and approved by the Board of Governors; it is not a market rate. The Fed’s 12 regional branches offer very short-term – generally overnight – loans to banks that are experiencing funding shortfalls in order to prevent liquidity problems or, in the worst-case scenario, bank failures. This lending facility is known as the deposit window; it is different from the interbank borrowing that institutions with deposits at the Fed do among themselves, which is governed by the federal funds rate.
The discount rate is actually three separate but related rates. The primary credit rate, which is sometimes referred to simply as the “discount rate” and should not be confused with the prime rate, is available to institutions with good credit. The secondary credit rate is available to institutions that do not qualify for the primary rate and is set 50 basis points higher than the primary rate. Both of these rates are set without regard to market rates. The seasonal credit rate is available to institutions that experience predictable seasonal fluctuations, such as banks serving agricultural and tourist communities. It is set every 14 days at the average of the daily effective federal funds rate and the three-month CD rate over the previous 14 days, meaning it’s affected by market interest rates.
Discount window loans are collateralized, unlike overnight loans at the federal funds rate.
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% to 5.75%, reducing the spread over the fed funds rate from 1 percentage point to 0.5, where it currently sits (from early 2008 to 2010 the spread was 0.25 percentage points). The board also extended the lending period from overnight to 30 days, then to 90 days in March 2008. Those measures were temporary, and the discount rate is once again used for overnight lending.
In October 2008, the month after Lehman Brothers’ collapse, discount window borrowing peaked at $403.5 billion; that compares to a monthly average of $0.7 billion from 1959 to 2006.
Other central banks have lending facilities similar to the Fed’s discount window. The European Central Bank’s are known as standing facilities, for example.
Discounted Cash Flow Analysis
The discount rate also refers to the rate used to determine the present value of cash flows in discounted cash flow analysis. For example, to determine the present value of $1,000 a year from now, you need to discount it by a particular interest rate. Assuming a discount rate of 10%, the present value would be $909.09, according to the formula below:
If you expect to receive $1,000 in two years, the present value would be $826.45 at a 10% discount rate.
What is the appropriate discount rate to use for a project? Many companies use their weighted average cost of capital (WACC) if the project’s risk profile is similar to that of the company. If the project’s risk profile is substantially different from that of the company, the Capital Asset Pricing Model (CAPM) is often instead.
The discount rate can also refer to the rate at which pension plans and insurance companies discount their liabilities.