Bank Discount Basis: Definition, Calculation, and Examples
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Summary:
Bank discount basis, also known as discount yield, is a common method used in finance, particularly in fixed-income securities trading. It represents the return on investment when purchasing bonds at a discount and selling them at face value upon maturity. Bank discount basis, also known as discount yield, is a convention used by financial institutions when quoting prices for fixed-income securities sold at a discount, such as municipal and U.S. Treasury bills. The quote is presented as a percentage of face value and is determined by discounting the bond by using a 360-day-count convention, which assumes there are twelve 30-day months in a year.
Understanding bank discount basis
The bank discount basis is an annualized yield stated as a percentage. It is the return on investment generated by purchasing the instrument at a discount and then selling it at par when the bond matures. Treasury bills, along with many forms of corporate commercial paper and municipal notes, are issued at a discount from par value (the face value).
U.S. Treasury bills have a maximum maturity of 52 weeks, while Treasury notes and bonds have longer maturity dates.
Day-count convention
While the 30/360 day-count convention is the standard banks use when quoting treasury bonds, the bank discount rate will be lower than the actual yield on your short-term money market investment, because there are 365 days in a year. Therefore, the rate should not be used as an exact measurement of the yield to be received.
Over longer maturities, the day count convention will have a greater impact on the current “price” of a bond than if the time to maturity is much shorter.
To convert a 360-day yield to a 365-day yield, simply “gross-up” the 360-day yield by the factor 365/360. A 360-day yield of 8% would equate to an 8.11% yield based on a 365-day year.
Pros and cons of bank discount
The bank discount basis, or bank discount rate, is calculated using the following formula:
Discount yield vs. bond accretion
Securities sold at a discount use the discount yield to calculate the investor’s rate of return, and this method is different than bond accretion. Bonds that use bond accretion can be issued at par value, at a discount, or at a premium, and accretion is used to move the discount amount into bond income over the remaining life of the bond.
Assume an investor purchases a $1,000 corporate bond for $920, and the bond matures in 10 years. Since the investor receives $1,000 at maturity, the $80 discount is bond income to the owner, along with the interest earned on the bond.
Bond accretion means the $80 discount is posted to bond income over the 10-year life, and an investor can use a straight-line method or the effective interest rate method. Straight-line posts the same dollar amount into bond income each year, and the effective interest rate method uses a more complex formula to calculate the bond income amount. Bonds with a coupon can also be quoted at on a yield basis.
Discount yield
Discount yield, also known as bank discount basis, is a method used to calculate the expected return on investment for securities sold at a discount to their par value. This calculation considers the difference between the purchase price and the face value of the security, along with the time to maturity.
Securities sold at a discount, such as treasury bills and commercial paper, use the discount yield method to determine the investor’s rate of return. The simplicity of the discount yield calculation makes it particularly suitable for short-term investments.
Bond accretion
Bond accretion, on the other hand, is a method used to adjust the carrying value of a bond over time, particularly for bonds purchased at a discount or premium to their par value. Unlike discount yield, which focuses on calculating the return on investment, bond accretion involves incrementally increasing the bond’s book value to reach its par value by the time of maturity.
Investors use bond accretion to recognize the amortization of the discount or premium on the bond over its remaining life. This method ensures that the bond’s carrying value aligns with its par value at maturity, allowing for a smooth transition of income recognition throughout the bond’s term.
Comparison and application
While discount yield and bond accretion serve different purposes in financial analysis, they are both essential tools for investors evaluating fixed-income securities.
- Discount yield provides a straightforward method for calculating the expected return on securities sold at a discount, offering clarity on the investment’s profitability.
- Bond accretion, on the other hand, helps investors track the incremental adjustment of a bond’s carrying value, ensuring accurate reporting of income and aligning with accounting standards.
Understanding the differences between discount yield and bond accretion allows investors to make informed decisions based on their investment objectives, time horizon, and risk tolerance. While discount yield is suitable for short-term investments, bond accretion is more relevant for long-term bond holdings requiring precise accounting treatment.
Conclusion
In conclusion, bank discount basis, also known as discount yield, is a fundamental concept in finance used to calculate the expected return on investment for fixed-income securities sold at a discount. Understanding the bank discount rate allows investors to assess the potential profitability of purchasing bonds at a discount and holding them until maturity.
Frequently asked questions
What is bank discount basis?
Bank discount basis, or discount yield, calculates the expected return of a bond sold at a discount to its par value. It is commonly used to determine the yield on treasury bills, commercial paper, and municipal notes.
How is the bank discount rate calculated?
The bank discount rate is calculated by dividing the discount from the par value by the par value itself, then multiplying by the number of days to maturity and dividing by 360.
What are the main uses of bank discount basis?
Bank discount basis is primarily used to determine the yield on fixed-income securities such as treasury bills, commercial paper, and municipal notes. It helps investors assess the potential return on investment when purchasing bonds at a discount.
Can bank discount basis be used for long-term investments?
While bank discount basis is commonly used for short-term investments due to its simplicity and ease of calculation, it may not be suitable for long-term investments. Long-term investments often involve more complex yield calculations and considerations for compounding.
How does bank discount basis differ from other yield calculation methods?
Bank discount basis differs from other yield calculation methods such as yield to maturity and current yield in its approach to calculating the expected return on investment. While bank discount basis focuses on the discount from the par value of the bond, other methods consider factors such as coupon payments and time to maturity.
What are the limitations of bank discount basis?
One limitation of bank discount basis is that it does not account for compounding, which may result in an underestimation of the true yield on an investment. Additionally, bank discount basis assumes a 360-day year and may not accurately reflect the actual number of days in a year.
Is bank discount basis suitable for all types of fixed-income securities?
Bank discount basis is commonly used for treasury bills, commercial paper, and municipal notes, which are typically short-term investments. While it may be suitable for these types of securities, investors should consider alternative yield calculation methods for longer-term investments or securities with more complex structures.
Key takeaways
- Bank discount basis calculates the expected return of a bond sold at a discount.
- It is commonly used for treasury bills, commercial paper, and municipal notes.
- The calculation is based on a 360-day year and a 30-day month.
- Bank discount basis does not account for compounding and may underestimate true yield.
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