Overview of Banker’s Discount
Definition
A banker’s discount refers to the discount calculated and applied by a bank when it purchases a bill of exchange before it matures. When a bill of exchange is sold to a bank, the bank deducts a certain amount as a discount, representing the interest for the period from the date of purchase until the date of maturity.
A bill of exchange is a written, unconditional order directing one party to pay a fixed amount of money to another party at a predetermined date.
Detailed Explanation
When businesses need immediate cash flow but hold bills of exchange, they may sell these financial instruments to a bank in exchange for funds. The bank, in turn, deducts an amount based on the time remaining until maturity and the agreed discount rate. This deducted amount is known as the banker’s discount, which compensates the bank for providing the cash upfront.
Example Calculation
Consider a business holding a 90-day bill of exchange with a face value of $10,000. If the bank’s discount rate is 5%, the banker’s discount would be calculated as follows:
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Identify the term of the bill: 90 days.
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Determine the nominal value of the bill: $10,000.
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Set the discount rate: 5% per annum.
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Calculate the discount for 90 days:
\[ \text{Banker’s Discount} = \frac{\text{Face Value} \times \text{Discount Rate} \times \text{Days to Maturity}}{365 , \text{days}} \]
\[ \text{Banker’s Discount} = \frac{10,000 \times 0.05 \times 90}{365} = $123.29 \]
Thus, the bank pays the business $9,876.71 for the bill of exchange.
Frequently Asked Questions
What is the difference between banker’s discount and true discount?
The banker’s discount is based on the face value of a bill of exchange, whereas true discount considers the present value of the bill. The true discount is the interest on the face value, calculated from the present value to its maturity.
Why do banks offer discounts on bills of exchange?
Banks offer discounts on bills of exchange to earn interest on the amount advanced, to facilitate liquidity for businesses, and to diversify their revenue streams through trade financing activities.
Is the banker’s discount rate fixed?
No, the banker’s discount rate can vary based on various factors, including current market conditions, the creditworthiness of the drawer, and the time remaining until the bill’s maturity.
What is the significance of a bill of exchange in banking?
A bill of exchange is significant in banking as it serves as a financial instrument used in trade finance to guarantee payment and secure credit. It helps facilitate international and domestic trade by providing a method of payment assurance.
Related Terms and Definitions
- Bill of Exchange: A written order directing one party to pay a specific sum to another party at a predetermined future date.
- Discounting Bills: The process by which banks buy bills of exchange before their maturity at a price below their face value.
- Trade Finance: The financing of international and domestic trade transactions through various instruments, including letters of credit, bills of exchange, and guarantees.
- Face Value: The nominal value stated on a financial instrument, such as a bill of exchange, that must be repaid at maturity.
Online Resources
Suggested Books for Further Study
- “International Trade Finance: A Practical Guide” by Kwai Wing Luk
- “Banking and Finance: Theory, Law, and Practice” by Gomez Clifford
- “Modern Banking” by Shelagh Heffernan
- “Trade Finance: International Payments and Loans” by Pietro Penza
Accounting Basics: “Banker’s Discount” Fundamentals Quiz
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