What is a Discount Rate?
The term discount rate can have one of two meanings. The discount rate can be used to describe the interest rate that an eligible depository institution can borrow funds from the federal reserve. The federal reserve sets two interest rates; the discount rate which we just discussed and the federal funds rate.
In calculating the value of a bond, discount rate may also refer to the interest rate that is used to calculate the present value of future cash flows. The formula is:
Future Value of Cash Flow / (1 + discount factor/number of coupon payments per year) ^ n
n = number of coupon periods in the future.
For example: Assuming semi-annual coupon payments at 5% and a coupon of $100; the present value of the coupon paid 1 year from now would be calculated as such:
$100 / (1 + .05/2) ^ 2 = $95.18