Understanding Discount Yield: A Comprehensive Guide for Investors
Introduction to Discount Yield
Discount yield is a financial measure used to determine the annualized return on discount securities, such as Treasury bills (T-bills). Unlike other investment instruments, T-bills are sold at a discount below their face value and mature at their full face value. This article aims to provide a detailed explanation of what discount yield is, how it is calculated, and how it is interpreted by investors.
What is Discount Yield?
Discount yield is a financial metric that helps investors understand the return on a discount security like a Treasury bill. When a T-bill is issued, it is sold at a price lower than its face value. At maturity, the investor receives the face value of the T-bill. The difference between the face value and the purchase price is the discount.
The Formula for Calculating Discount Yield
The formula for calculating discount yield is:
Discount Yield (Face Value - Purchase Price) / Face Value times; 360 / Days to Maturity
Let's break down the components of this formula:
Face Value: This is the amount the security will be worth at maturity, usually denoted as FV.
Purchase Price: This is the price at which the security is purchased, denoted as PP.
Days to Maturity: The number of days remaining until the security matures, typically measured on a 360-day basis, denoted as DM.
Interpretation of Discount Yield
A higher discount yield indicates a greater return relative to the purchase price. It is important to note that the discount yield is often expressed as a percentage. This helps investors compare the attractiveness of various short-term investments.
Example: Calculating Discount Yield
Consider a T-bill with a face value of $1,000 that is purchased for $950 and has 90 days until maturity. The discount yield would be calculated as follows:
Discount Yield (1,000 - 950) / 1,000 times; 360 / 90
Pulling out the numbers:
0.05 times; 4 0.20 or 20%
Thus, the annualized return on the T-bill is 20%. This means for each $1,000 invested in the T-bill, an investor would receive a return of $200 annually.
Discount Yield vs. Market Yield
It is also worth noting that the market yield, which is the yield to maturity of a bond, can be different from the discount yield. If a bond is issued at a discount, its market yield will be higher than its current yield, compensating the investor for the discount given on the bond. This means that if a bond is issued at 6% but the current market yield is 7%, the trading value of the bond will adjust to reflect this market condition, ensuring that the yield to maturity matches the market yield.
Conclusion
In summary, discount yield provides a valuable tool for investors to evaluate the return on T-bills and other discount securities. Understanding how discount yield is calculated, interpreted, and how it relates to other yield measures like market yield is crucial for making informed investment decisions.