Discount Yield

Definition

Discount Yield refers to the annualized yield of a security sold at a discount, such as U.S. Treasury bills (T-bills). It is a simple formula used to approximate the return on investment from the difference between the purchase price and the face value of the security.

Calculation

To calculate the annual discount yield:

1. Determine the discount amount, which is the difference between the face value and the purchase price of the security.
2. Divide the discount by the face value of the security.
3. Multiply the resulting number by 360 (an approximation of the number of days in a year) and then divide by the number of days until maturity.

Example

Consider a U.S. Treasury bill purchased at $9,750 and maturing at $10,000 in 90 days:

1. Discount = $10,000 (Face Value) - $9,750 (Purchase Price) = $250
2. Discount Yield = $\frac{250}{10,000} \times \frac{360}{90} = 0.01 \times 4 = 0.04$ or 4%

Frequently Asked Questions

Q1: What is the benefit of using the discount yield method?

A1: The discount yield method is beneficial for investors looking for a straightforward way to calculate the annualized return on short-term debt securities sold at a discount.

Q2: Can the discount yield be applied to any security?

A2: No, discount yield specifically applies to securities sold at a discount, such as T-bills and commercial paper. It is not suitable for bonds or other securities sold with interest.

Q3: Does the discount yield account for compounding interest?

A3: No, discount yield does not account for the compounding of interest; it is a simple annualized percentage based only on the linear calculation.

Q4: Why do we use 360 instead of 365 days in the calculation?

A4: Using 360 days is a convention in the financial industry for ease of calculation, especially for short-term instruments.

Q5: How does the discount yield differ from the bond equivalent yield?

A5: The bond equivalent yield annualizes the yield over a 365-day period and semiannual compounding, providing a bond’s comparable rate for securities. Discount yield uses a 360-day base and does not consider compounding.

Related Terms

• Yield to Maturity (YTM): The total return anticipated if a bond is held until it matures, considering both interest payments and the difference between its current market price and par value.
• Current Yield: The annual interest payment divided by the current market price of the bond, not accounting for capital gains or losses at maturity.
• Bond Equivalent Yield (BEY): An annualized yield that helps compare discount securities with bonds that pay semiannual interest.

Online References

1. Investopedia: Discount Yield
2. Treasury Direct: Treasury Bills

Suggested Books for Further Studies

1. “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
2. “The Bond Book” by Annette Thau
3. “Investing in Bonds For Dummies” by Russell Wild

Fundamentals of Discount Yield: Finance Basics Quiz

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