What is the Discount Market?
Definition
The discount market in the United Kingdom is a specialized sector of the money market involving banks, discount houses, and bill brokers. This market’s primary function is the discounting or selling of bills of exchange, particularly Treasury bills, at rates lower than their face values in order to provide short-term liquidity and enable financial entities to earn profits through arbitrage.
Key Participants
- Banks: Financial institutions that lend and borrow money and offer various financial services.
- Discount Houses: Specialized finance firms that buy and sell short-term paper such as Treasury bills and commercial bills at a discount.
- Bill Brokers: Intermediaries that facilitate the buying and selling of bills of exchange between banks and other financial institutions.
Importance
The discount market is crucial for maintaining liquidity in the financial system. It allows for the straightforward and efficient conversion of short-term securities into cash, thereby supporting the financial needs of businesses and governments.
Examples
Example 1: Treasury Bills
A bill broker buys a £1,000 Treasury bill maturing in 90 days at a discounted price of £990 from a commercial bank. Upon maturity, the broker earns a £10 profit.
Example 2: Commercial Bills
A discount house purchases a £5,000 commercial bill issued by a corporation due in six months at a discounted price of £4,930. The discount house will profit £70 when the bill matures.
Frequently Asked Questions
What is “discounting” in finance?
Discounting is the process of selling a bill or financial instrument at a price lower than its face value. The difference between the purchase price and face value represents the profit upon maturity.
How does the discount market support liquidity?
By facilitating the sale and purchase of bills at short notice, the discount market allows banks and financial institutions to quickly raise cash, thereby maintaining liquidity.
What are Treasury bills?
Treasury bills are short-term debt instruments issued by the government to finance its immediate needs and are typically sold at a discount to their face value.
What roles do discount houses play?
Discount houses specialize in buying and selling short-term paper at discounts, supporting liquidity in the market by making short-term funds available for banks and other institutions.
Money Market
A segment of the financial market in which financial instruments with high liquidity and short maturities are traded.
Bills of Exchange
A written order binding one party to pay a fixed sum of money to another party at a predetermined future date.
Treasury Bills (T-Bills)
Short-term government securities with maturities of one year or less that are sold at a discount from their face value.
Arbitrage
The simultaneous purchase and sale of the same or similar financial instruments in different markets to profit from price discrepancies.
Online References
Suggested Books for Further Studies
- “The Essentials of Finance and Investment” by Allen J. C.
- “The Only Guide to a Winning Bond Strategy You’ll Ever Need” by Larry Swedroe.
- “The Economics of Money, Banking and Financial Markets” by Frederic S. Mishkin.
Accounting Basics: Discount Market Fundamentals Quiz
### What is the primary purpose of the discount market?
- [x] To provide short-term liquidity and enable financial entities to earn profits.
- [ ] To facilitate long-term investments.
- [ ] To manage personal savings accounts.
- [ ] To trade real estate property.
> **Explanation:** The primary purpose of the discount market is to provide short-term liquidity and enable financial institutions and entities to earn profits through the discounting of bills.
### Who are the primary participants in the discount market?
- [x] Banks, discount houses, and bill brokers.
- [ ] Stock brokers, insurance companies, and mutual funds.
- [ ] Mortgage brokers, realtors, and landlords.
- [ ] Individual retail investors only.
> **Explanation:** The primary participants in the discount market are banks, discount houses, and bill brokers who facilitate the trading of discounted bills and short-term instruments.
### What financial instruments are commonly traded in the discount market?
- [ ] Long-term bonds and equities.
- [ ] Real estate properties and mortgages.
- [x] Treasury bills and commercial bills.
- [ ] Commodities and precious metals.
> **Explanation:** Treasury bills and commercial bills are commonly traded in the discount market as short-term instruments.
### How is profit made in the discount market?
- [ ] Through rental income from leased properties.
- [ ] By charging high interest on long-term loans.
- [x] By selling bills below their face value and redeeming them at face value upon maturity.
- [ ] By appreciating stock prices over time.
> **Explanation:** Profit is made in the discount market by selling bills at a discounted price and redeeming them at their face value upon maturity.
### What is a key feature of Treasury bills?
- [ ] They have no maturity date.
- [x] They are sold at a discount to their face value.
- [ ] They are issued in foreign currencies.
- [ ] They are illiquid financial instruments.
> **Explanation:** A key feature of Treasury bills is that they are sold at a discount to their face value and are short-term debt instruments.
### Why is liquidity important in the discount market?
- [x] It ensures that short-term financial needs are met efficiently.
- [ ] It ensures that long-term investments are profitable.
- [ ] It exclusively benefits real estate transactions.
- [ ] It guarantees higher interest rates on savings accounts.
> **Explanation:** Liquidity is crucial in the discount market as it ensures that short-term financial needs are met efficiently, enabling quick access to funds.
### In what way do discount houses contribute to the discount market?
- [ ] By issuing long-term bonds.
- [x] By buying and selling short-term paper at discounts.
- [ ] By providing unsecured personal loans.
- [ ] By facilitating insurance contracts.
> **Explanation:** Discount houses contribute to the discount market by buying and selling short-term paper at discounts, helping maintain market liquidity.
### Which term describes the process of selling a financial instrument for less than its face value?
- [ ] Accumulating
- [x] Discounting
- [ ] Amortizing
- [ ] Leveraging
> **Explanation:** The term "discounting" describes the process of selling a financial instrument for less than its face value to provide liquidity and earn profit upon maturity.
### What type of market is the discount market a part of?
- [ ] Real estate market
- [ ] Commodities market
- [x] Money market
- [ ] Capital market
> **Explanation:** The discount market is a part of the money market, where short-term financial instruments with high liquidity are traded.
### How does the discount market impact the financial system?
- [ ] It restricts the flow of capital.
- [ ] It increases long-term debts.
- [x] It ensures efficient conversion of short-term securities into cash.
- [ ] It reduces market volatility.
> **Explanation:** The discount market ensures the efficient conversion of short-term securities into cash, supporting liquidity in the financial system.
Thank you for exploring the discount market with us and challenging your understanding through our sample quiz. Continue to strive for a deeper comprehension of financial systems and practices!
