Lesson 3 of 5 · 12 min

Money market yields and the discount rate basis

Money market rates are simple, annualized rates with their own quoting rules; a discount rate divides the interest by the face value, so it understates the true return.

In short

  • Money market instruments have original maturities of one year or less: T-bills, commercial paper, bankers' acceptances, CDs, repos and others.
  • Unlike bond YTMs, money market rates are annualized but not compounded (simple interest), their periodicity = Year/Days differs by maturity, and they use non-standard pricing formulas.
  • Quotes are either discount rates (DR) or add-on rates (AOR). T-bills, commercial paper and bankers' acceptances are often quoted on a discount basis.
  • Price on a discount basis: PV=FV×(1−DaysYear×DR)PV = FV \times (1 - \frac{Days}{Year} \times DR).
  • DR=YearDays×FV−PVFVDR = \frac{Year}{Days} \times \frac{FV - PV}{FV}: interest over face value, not over the amount invested, so a positive DR understates the investor's return and the issuer's borrowing cost.

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Money market yields and the discount rate basis · Yield and Yield Spread Measures for Floating-Rate Instruments