CHAPTER 6:
BANK DISCOUNT
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Slide 1
Chapter 6
BANK DISCOUNT
Promissory Notes, Simple
Discount Notes, and
The Discount Process
McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved
REFERENCES
➢ Law No.49/2005/QH11 of November
29, 2005 on Negotiable Instruments
➢ Circular 04/2013/TT-NHNN of March
01,2012 on regulations about discount
of negotiable instruments in banks.
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LEARNING OUTCOMES
➢ Present what is Discount, types of
discount documents and discounting
process.
➢ Practice steps of discounting process and
discounting techniques; calculate the
discount rate.
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DEFINITION
• Discount means purchase of negotiable
instruments by a credit institution from
the beneficiary prior to its maturity for
payment.
• The process of converting values
expressed in dollars received at a point in
time to an equivalent value expresses in
dollars received at an earlier point in
time.
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DEFINITION
• Types of financial instruments:
▪ Commercial papers (Bills of
exchange, promissory note…)
▪ Treasury note, bond, CDs...
While discounting a bill, the Bank buys the bill (i.e.
Bill of Exchange or Promissory Note) before it is due
and credits the value of the bill after a discount charge
to the customer's account.
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7
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CONDITIONS
➢ A bill must be a usance bill.
➢ It must have been accepted and bears at least two good
signatures (e.g. of reputable individuals, companies or
banks etc.)
➢ The Bank will normally only discount trade bills.
➢ Where a usance bill is drawn at a fixed period after
sight the bill must be accepted to establish the maturity.
8
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CONDITIONS
➢ The discount should be based on real trade
background.
➢ The discount tenor starts from the date of
discount and expires at the maturity of the bill.
9
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Discounting Process of Commercial Papers
Buyer
Seller
Discount
bank
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Discount Export Documents
Importer Exporter
Issuing Discount
Bank bank
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TYPICAL RISKS OF DISCOUNT
• Fake commercial papers
▪ Accommodation papers
▪ Commercial Papers were born that are not
based on the real transactions
• Drawer who issue the commercial papers is
not able to pay
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DISCOUNT TECHNIQUES
• Discounting procedure:
▪ Analyze discount documents
▪ Determine present value
▪ Funding
▪ Collecting
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DISCOUNT TECHNIQUES
▪ Analyze discount documents
o Legal or illegal?
o How is the reputation of drawer?
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DISCOUNT TECHNIQUES
▪ Determine Present Value
G = M- Mxixt Transaction
-
Fees
• M : Face value at maturity (FV)
• i : Discount rate (annually)
• t : Period of time (daily)
• G : Present value (PV)
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Simple Discount Note
Simple discount note - A note in Bank discount - the interest that
which the loan interest is banks deduct in advance
deducted in advance
Maturity Value – The total
amount due at the end of the loan
Proceeds - the amount the
Bank discount rate - the borrower receives after the bank
percent of interest deducts its discount from the
loans maturity value
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Simple Discount Note - Example
Terrance Rime borrowed $10,000 for 90 days from
Webster Bank. The bank discounted the note at 10%.
What proceeds does Terrance receive?
$10,000 x 0.10 x 90 = $246.5
365 Bank Discount
Bank Discount
Rate
$10,000 - $246.5 = $9,753.5
Proceeds
The actual amount the borrower receives after paying
the discount to the bank.
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Comparison of Simple Interest Note vs Simple
Discount Note
Simple
Simple
Interest
Interest
NoteNote
- Ch. 10 Simple
Simple
Discount
Discount
Note Note
- Ch. 11
Interest Interest
I = Face Value (Principal) x R x T I = Face Value (Principal) x R x T
I = $14,000 x .08 x 60 I = $14,000 x .08 x 60
360
36 360
$187.67
I = $18 I = $186.67
Maturity Value Maturity Value
MV = Face Value + Interest MV = $14,000
MV = $14,000 + $ 186.67=$14,186.67
187.67=$14,187.67
Proceeds Proceeds
Proceeds = Face Value Proceeds = MV - Bank discount
Proceeds = $14,000 Proceeds = $14,000 – 186.67
Proceeds = $13,813.33
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Comparison - Effective Rate
Simple Interest Note Simple Discount Note
Rate = Interest Rate = Interest
Proceeds x Time Proceeds x Time
Rate = $186.67 Rate = $186.67
$14,000 x 60 $13,813.33 x 60
360 360
Rate = 8% Rate = 8.11%
The effective rate for a simple discount note is
higher than the stated rate, since the bank
calculated the rate on the face of the note and not
on what Terrance received
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Comparison of simple interest
note and simple discount note
Simple interest note Simple discount note
1. A promissory note for a loan with a term of usually 1. A promissory note for a loan with a term of usually
less than 1 year. Example: 60 days less than 1 year. Example: 60 days
2. Paid back by one payment at maturity. Face value 2. Paid back by one payment at maturity. Face value
equals actual amount (or principal) of loan (this is not equals maturity value (what will be repaid)
maturity value)
3. Interest computed on maturity value or what will be
3. Interest computed on face value or what is actually repaid and not on actual amount borrowed. Example:
borrowed. Example: $186.67 $186.67
4. Maturity value = Face value + Interest 4. Maturity value = Face value
Example: $14, 186.67 Example: $14, 000
5. Borrower receives the face value 5. Borrower receives proceeds = Face value - bank
Example: $14,000 discount. Example: $13,813.33
6. Effective rate (true rate is same as rate stated on 6. Effective rate is higher since interest was deducted
note). Example: 8% in advance. Example: 8.11%
7. Used frequently instead of the simple discount note. 7. Not used as much now because in 1969
Example: 8% congressional legislation required that the true rate of
interest be revealed. Still used where legislation does
not apply, such as personal loans.
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Practice
Non-interest bearing note of $12,000.
Simple discount rate of 9.5%
60-day note.
1. What is the maturity value?
2. What is the bank discount?
3. What is the proceeds to the borrower?
4. What is the effective rate? Is it 9.5%?
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Key to Practice
Non-interest bearing note of $12,000.
Simple discount rate of 9.5%
60-day note.
Maturity value = Face value = $12,000
Bank discount = Maturity value x Bank discount rate x Time
Bank discount = 12,000 x 0.095 x 60/365 = $187
Proceeds = Maturity value – Bank discount
Proceeds = $12,000 - $187 = $11,813
Effective rate = Interest $187
_________________ = ____________ = 9.65%
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Proceeds x Time/365 11,813 x 60/365
Treasury Bills
Loan to Federal Govt.
Terms of Purchase
91 days
or
1 Year
If you buy a $10,000 $10,000 x 0.08 x 91 = $200
91 days Treasury bill 365
at 8%, how much
Cost to buy = $10,000 - $200 = $9,800
will you pay and
what is the effective Effective Rate = $200 = 8.16%
rate? $9,800 x 91
365
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Problem :
Solution: Treasury bill $10,000 at 5% rate;
91 days Treasury bill.
$10,000 x 0.05 x 91 = $125
365 Interest earned
Actual cost to pay for Treasury bill = 10,000 – 125 = $9,875
Effective rate = $125 _ = 5.06%
$9,875 x 91
365
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Practice
Treasury bill for $10,000 for 91 days;
Discount value in buying bill = $23.90
Solution: Find the effective rate of Treasury bill.
$23.90 _ $23.90
= = 0.95829% = 0.96%
$9,976.10 x 91 $2,494.025
365
($10,000.00 - $23.90) = $9,976.10 (Actual cost to buy
Treasury bill)
$10,000.00 - $9,976.10
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Discounting an Interest-Bearing
Note before Maturity
Step 4. Calculate the
proceeds
Step 3. Calculate the bank discount
Step 2. Calculate the discount period
(time the bank holds note)
Step 1. Calculate the interest and maturity value
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Discounting an Interest-Bearing
Note before Maturity
Camille Wilson sold the following promissory note to the bank:
Date of Face Value Length of Interest Bank Discount Date of
note of note note rate rate discount
March 8 $2,000 185 days 10% 9% August 9
Date of Date of Date
note discount note due
31 days
154 days before note is discounted Bank waits
March 8 August 9 Sept. 9
185 days total length of note
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Discounting an Interest-Bearing
Note before Maturity
Camille Wilson sold the following promissory note to the bank:
Date of Face Value Length of Interest Bank Discount Date of
note of note note rate rate discount
March 8 $2,000 185 days 10% 9% August 9
What are Camille’s interest and maturity value? What are the
discount period and bank discount? What are the proceeds?
I = $2,000 x0 .10 x 185 = $102.78
365
MV = $2,000 + $102.780 = $2,102.78
$2,102.78 x 0.09 x 31 = 16.30
365 $2102.78 – 16.30 = $2,068.48
Calculation
on next slide
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Calculation of days without table
Manual Calculation Table Calculation
March 31 August 9 221 days
-8 March 8 -67 days
23 154 days passed
before note is discounted
April 30
185 day note
May 31
-154
June 30 31 discount pd.
July 31
August 9 185 days - length of note
154 -154 days Camille held note
31 days bank waits
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Problem :
May 8: $3,000, 8%, 180-day note
August 16: Discounted at bank at 9% discount
Solution: rate
Bank Discount
Aug. 16 228 days
May 8 -128 80
100 days passed $3,120.00 x .09 x =62.40
365
180 – 100 = 80 days $3,120.00 (MV)
(discount period)
- 62.40 (Bank discount)
180 $3,057.60 proceeds
$3,000 x .08 x 365 = $120
$3,000 + $120 = $3,120
(Maturity Value)
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Problem :
August 8: $5,000, 8%, 120-day note
Oct 11: discounted at bank at 9%
Solution:
Oct 11 284 days
Aug 8 - 220
64 days passed
120 – 64 = 56 days
(discount period)
$5,000 x .08 x 120 = $133.33 Interest earned on original note
365
$5,000 + $133.33 = $5,133.33 Maturity Value
Bank discount= $5,133.33 x 0.09 x 56/365 = $71.87
Proceeds = $5,133.33 – 71.87 = $5,061.46
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