Discount rate
The discount rate is the interest rate the Federal Reserve charges banks for direct loans from its discount window. In valuation, the same term means the rate used to discount future cash flows to their present value.
The term discount rate carries two distinct meanings in finance, and securities exams test both. In monetary policy, the discount rate is the interest rate the Federal Reserve charges banks that borrow directly from the Fed's discount window. In valuation and time-value-of-money problems, a discount rate is the rate used to translate future cash flows into today's dollars.
As a Fed tool, the discount rate is one of the few interest rates the Federal Reserve sets directly (unlike the federal funds rate, which it targets but banks negotiate among themselves). Borrowing at the window carries some stigma — it can signal that a bank couldn't borrow from peers — so the discount rate is generally set above the federal funds rate. Raising the discount rate is contractionary policy; lowering it encourages lending and expands the money supply.
In valuation, the discount rate expresses the time value of money and risk: a dollar received years from now is worth less than a dollar today. Present value = future value ÷ (1 + r)ⁿ, where r is the discount rate. The higher the discount rate, the lower the present value. This is the engine behind the dividend discount model for valuing stock and discounted cash flow analysis generally.
The SIE exam tests the discount rate among the Federal Reserve's tools and benchmark rates — remember the ordering with the federal funds rate and prime rate — while the Series 65 and Series 66 exams also apply the valuation meaning in time-value-of-money and dividend discount questions.
Key takeaways
- The Fed's discount rate is what banks pay to borrow directly from the Federal Reserve's discount window.
- It is set directly by the Fed and typically sits above the federal funds rate; raising it is contractionary.
- In valuation, the discount rate converts future cash flows to present value — higher rates mean lower present values.
- Exams test both meanings: know the benchmark-rate ordering and the present value mechanics.