What Is the Discount Rate?

In economics and finance, the term "discount rate" could mean one of two things, depending on context. On the one hand, it is the interest rate at which an agent discounts future events in preferences in a multi-period model, which can be contrasted with the phrase discount factor. On the other, it means the rate at which United States banks can borrow from the Federal Reserve.

For the purpose of this article, we will focus on the discount rate as it applies to present value — in a discrete time model of business interests, where agents discount the future by a factor of b, one finds that the rate is equal to the difference of one minus b divided by b, which can be written r=(1-b)/b.

This discount rate is essential to calculating the discounted cash flow of a company, which is used to determine how much a series of cash flows in the future is worth as a lump sum total today. In practical application, the discount rate can be a useful tool for investors to determine the potential value of certain businesses and investments who have an expected cash flow in the future.

Time, Value, and Uncertainty Risk

In order to determine the current value of future cash flow, which is essentially the point of applying the discount rate to business endeavors, one must first evaluate the time value of money and the uncertainty risk wherein a lower discount rate would imply lower uncertainty the higher the present value of future cash flow.

The time value of money is different in the future because inflation causes cash flow tomorrow to not be worth as much as cash flow is today, from the perspective of today; essentially this means that your dollar today will not be able to buy as much in the future as it could today.

The uncertainty risk factor, on the other hand, exists because all prediction models have a level of uncertainty to their predictions. Even the best financial analysts cannot fully predict unforeseen events in a company's future like decreases in cash flow from a market collapse.

As a result of this uncertainty as it relates to the certainty of the value of cash presently, we must discount future cash flows in order to properly account for the risk a business makes in waiting to receive that cash flow.

The Federal Reserve's Discount Rate

In the United States, the U.S. Federal Reserve controls the discount rate, which is the interest rate for the Federal Reserve charges commercial banks on loans they receive. The Federal Reserve's discount rate is broken into three discount window programs: primary credit, secondary credit, and season credit, each with its own interest rate.

Primary credit programs are reserved for commercial banks in high standings with the Reserve as these loans are typically only given for a very short time (typically overnight). For those institutions not eligible for this program, the secondary credit program can be used to finance short-term needs or resolve financial difficulties; for those with financial needs that vary throughout the year, such as banks near summer getaways or large farms that only harvest twice a year, seasonal credit programs are also available.

According to the Federal Reserve's website, "The discount rate charged for primary credit (the primary credit rate) is set above the usual level of short-term market interest rates... The discount rate on secondary credit is above the rate on primary credit... The discount rate for seasonal credit is an average of selected market rates." In this, the primary credit rate is the Federal Reserve's most common discount window program, and the discount rates for the three lending programs are the same across all Reserve Banks except on days around a change in the rate.

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