Discount rate
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Discount rate as used in finance and economics is distinct from the discount rate described below; please refer to discounting and discounts.
The discount rate is different from a more normal interest rate. The two are separate concepts in financial mathematics. The discount rate is based on the future cash flow in lieu of the present value of the cash flow. The divisor, for the discount rate, is the resulting future value, including the income. The divisor in the calculation of interest is the original investment.
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:
The interest rate on the cash flow is calculated using 80 as its base:
It should become apparent that for every interest rate, there is a corresponding discount rate, given by the following formula:
Another way to think of a discount rate is to consider that the discount rate tells you how much of your future value is interest and how much is principal. For example, if you deposit $100 into an account that pays 50% interest, the amount that you will subsequently withdraw will be $150. Your discount rate is 0.5/(1+0.5) = 1/3 or 33.3%. Based on this, you can say that 33.3% of your $150 is interest and the other 66.7% is principal.
[edit] Context Specific Uses
- 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.
- Monetary Policy
- The discount rate is the 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 and Investment Valuation
- The interest rate that is used to calculate the Internal rate of return or Net present value of investments is NOT the discount rate as defined here. Similarly Discounted cash flow uses the normal calculation of interest, not the discount rate defined here.
[edit] Economic Policy
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%, 3.6845%, 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.
