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:
- Determine the discount amount, which is the difference between the face value and the purchase price of the security.
- Divide the discount by the face value of the security.
- 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:
- Discount = $10,000 (Face Value) - $9,750 (Purchase Price) = $250
- 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§
Suggested Books for Further Studies§
- “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
- “The Bond Book” by Annette Thau
- “Investing in Bonds For Dummies” by Russell Wild
Fundamentals of Discount Yield: Finance Basics Quiz§
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