Define Bank Discount Basis:

"The Bank Discount Basis is a method used to calculate the yield or return on certain debt instruments, primarily short-term money market instruments such as Treasury bills or commercial paper."

Explain Bank Discount Basis:

Introduction

The Bank Discount Basis is a method used to calculate the yield or return on certain debt instruments, primarily short-term money market instruments such as Treasury bills or commercial paper. It represents an alternative approach to measuring the return on investment compared to other conventional yield calculation methods.

This article explores the concept of Bank Discount Basis, its calculation, and its applications in the financial world.

What is Bank Discount Basis?

Bank Discount Basis, also known as Discount Yield or Money Market Basis, is a method of expressing the yield on short-term debt instruments as a simple discount from the face value of the instrument. Instead of calculating the yield based on interest rates or coupon payments, the Bank Discount Basis measures the difference between the purchase price of the instrument and its face value at maturity.

Calculation of Bank Discount Basis

The formula to calculate the Bank Discount Basis is as follows:

Bank Discount Basis = (Discount Amount / Face Value) * (360 / Number of Days to Maturity)

Where:

• Discount Amount is the difference between the face value and the purchase price of the debt instrument.
• Face Value is the nominal or par value of the instrument.
• Number of Days to Maturity refers to the number of days from the purchase date to the maturity date of the instrument.

Example Calculation

Suppose an investor purchases a Treasury bill with a face value of $10,000 for $9,800 and holds it for 90 days until maturity. The Bank Discount Basis can be calculated as follows:

Discount Amount = Face Value - Purchase Price = $10,000 - $9,800 = $200

Bank Discount Basis = ($200 / $10,000) * (360 / 90) = 0.02 or 2%

Therefore, the yield on the Treasury bill using Bank Discount Basis is 2%.

Applications of Bank Discount Basis

The Bank Discount Basis is commonly used for short-term debt instruments that are traded in the money market. Some of its applications include:

1. Treasury Bills: Government-issued Treasury bills are often quoted and traded on a discount basis, with the yield expressed as the discount from the face value.

2. Commercial Paper: Short-term debt securities issued by corporations are also quoted on a discount basis, facilitating easy comparison of yields.

3. Money Market Funds: Investors in money market funds can assess the yields on the fund's underlying securities using Bank Discount Basis.

Comparison with Other Yield Calculations

The Bank Discount Basis provides a different perspective on the yield compared to other methods like the Yield to Maturity (YTM) or Current Yield. While YTM considers the present value of all cash flows, including coupon payments, Bank Discount Basis focuses solely on the discount from the face value.

Conclusion

The Bank Discount Basis is a useful method for calculating yields on short-term debt instruments in the money market. By expressing the return as a simple discount from the face value, it offers a straightforward way to assess the profitability of these investments.

Investors and market participants can use Bank Discount Basis to evaluate the potential returns of Treasury bills, commercial paper, and other short-term debt securities, aiding them in making informed financial decisions.