Discount
When a security trades at a price below its face value, this is called a discount. To determine the size of the discount, it is necessary to divide the bond par value by its current market price. A discount expressed in percentage.
What is a Discount
The original price of a new bond is always fixed and called the par value. It is the amount that will be paid by the issuer to the investor by the time of the bond maturity. In most cases, the bond has a par value of $1,000. But with the beginning of trading in the market, the bond can sell at premium (for example, when it sold at $1,050) or at discount (for example, when it sold at $950).
A bond can trade at a discount for causes that depend, for example, on the financial problems of the issuer or increase in interest rates. Sometimes a discount can point out that the company may be in default.
When a bond trades in a lower interest rate (coupon) than the current market interest rate, it will become less appealing for an investor than newly issued bonds with higher coupons. To be competitive, these bonds should be discounted and sold on a lower price since the issuer doesn’t offer the same high rate to the holder. Historically, the term “coupon” appeared at that time when instead of electronic bonds traded in the market today there were physical certificates, to which real coupons were actually attached.
The term discount differs from the discount rate. The concept of a discount rate means the rate of return, expressed as a percentage, in which an investor is interested in investing a certain amount of funds in a particular enterprise. Also, the discount rate is needed to bring future cash flows to today. It is often designed to reflect the time value of money, taking into account the risk factor, since the funds received right now have a higher value than those
A pure Discount instrument
A type of bond without any coupons in which only the full par value is paid at maturity is called a pure discount instrument. Instead, the bond is sold at a significant discount, which is called a deep discount. This term refers to all bonds traded at a price below 20% of the market.
Assume that the pure discount instrument was purchased at a price of 800 dollars, but its par value is 1,000 dollars, so at maturity the client will receive a profit of 200 dollars (the total received amount will be equal to the par value—1000 dollars).
A pure discount bondholder does not receive a permanent income from the asset, this bond is also called a zero-coupon bond. This type of bond is more susceptible to fluctuations than coupon bonds.
Any investor is interested in the increase in his bond price as a result. The final value of the asset is the most important factor for him. In most cases, if a bond is bought by an investor at a high discount, then the expected rate of return at maturity will be also high.
Other Discount types
A discount may also be applicable to other financial market instruments, but it is not always linked to interest rates. In the case of stock shares or derivatives, a reduction in the price and discount formation in the market can be caused by artificially creating bargain news and noise around a particular company.
Another discount type is a cash discount, which can be given by the seller to the customer at the time of purchasing any product or service. Basically, this measure helps to attract customers and increase sales for businesses. A discount may also be a stimulus for the customer to pay a bill before the target date, through which the seller can reduce his risks.
