Discount finance: Meaning, Criticisms & Real-World Uses

What Is Discount Finance?

Discount finance is a method of obtaining funds by selling an asset or a future payment right at a price lower than its face value. The difference between the discounted price and the face value represents the cost of borrowing or the yield to the buyer. This approach is prevalent in money market instruments and other short-term debt arrangements, forming a core concept within financial markets. Entities use discount finance to generate immediate liquidity without waiting for an asset's natural maturity or a receivable's payment date.

History and Origin

The practice of discount finance has deep roots, particularly with the historical development of commercial paper. As early as the late 1700s in New York, merchants and manufacturers relied on this method to finance trade and goods when traditional bank credit was scarce. They would issue notes, drafts, or bills of exchange, representing trade acceptances or receivables, and then sell these documents at a discount to investors and dealers in the money market for immediate working capital. This practice evolved into the issuance of short-term promissory notes. For example, Marcus Goldman, the founder of Goldman Sachs, began his career trading commercial paper in New York in 1869, buying I.O.U.s from merchants at a discount and re-offering them to banks and other investors.⁴,³

Key Takeaways

Discount finance involves selling a financial instrument or future payment right for less than its face value.
The difference between the sale price and face value represents the cost of financing for the seller and the return for the buyer.
It is a common method for businesses and governments to raise short-term capital.
Common instruments include commercial paper, Treasury bills, and discounted receivables.
The actual return to the investor is realized when the instrument matures at its full face value.

Formula and Calculation

The core of discount finance involves calculating the discount amount and the effective yield. For a simple discount instrument, the discount amount is subtracted from the face value to determine the purchase price. The yield to maturity can be calculated using the following formula:

\text{Yield} = \frac{\text{Face Value} - \text{Purchase Price}}{\text{Purchase Price}} \times \frac{360}{\text{Days to Maturity}}

Where:

Face Value = The amount that will be paid at the maturity date.
Purchase Price = The discounted price at which the instrument is bought.
Days to Maturity = The number of days remaining until the instrument matures.
360 = The number of days in a year for money market conventions (sometimes 365 is used).

This formula helps determine the annual equivalent interest rate earned by the buyer of the discounted instrument.

Interpreting Discount Finance

Discount finance is interpreted by both borrowers and lenders based on the implied cost of funds and the expected return. For an issuer, the deeper the discount, the higher the cost of obtaining immediate capital. Conversely, for an investor, a larger discount (all else being equal) indicates a higher potential return on their investment. For example, a Treasury bills issued at a discount indicates the government's cost of borrowing for that short period. The market's perception of the issuer's credit rating heavily influences the discount offered, as higher risk typically demands a greater discount to compensate investors.

Hypothetical Example

Imagine Corporation XYZ needs $980,000 for a short-term operational expense. Instead of taking out a traditional loan, they decide to issue a 90-day promissory note with a face value of $1,000,000. They sell this note at a discounted price of $980,000 to an investor.

Here's how the discount finance works:

Issue Price: $980,000
Face Value (Maturity Value): $1,000,000
Term: 90 days

The investor pays $980,000 today and, after 90 days, receives $1,000,000 from Corporation XYZ. The $20,000 difference ($1,000,000 - $980,000) represents the implicit interest or the cost of the discount finance for Corporation XYZ. The investor's yield on this transaction would be calculated based on this $20,000 return over 90 days.

Practical Applications

Discount finance is widely used in various segments of the financial world:

Corporate Funding: Large corporations frequently issue commercial paper at a discount to meet short-term funding needs for inventory, payroll, or other operational expenses. These instruments are unsecured promissory notes, making them reliant on the issuer's credit rating.
Government Borrowing: Governments utilize discount finance through the issuance of Treasury bills. These short-term securities are sold at a discount from their face value and mature at par, providing a very low-risk investment for buyers.
Trade Finance: In trade finance, instruments like banker's acceptances are often discounted, allowing exporters to receive immediate payment for goods shipped, while importers can pay later.
Invoice Discounting/Factoring: Businesses can sell their accounts receivable to financial intermediaries at a discount to obtain immediate cash, rather than waiting for clients to pay their invoices.

During the 2008 financial crisis and again in 2020 during the COVID-19 pandemic, the Federal Reserve Board established the Commercial Paper Funding Facility (CPFF) to stabilize the short-term funding markets by purchasing commercial paper directly from eligible issuers, ensuring liquidity when other avenues became constrained.

Limitations and Criticisms

While discount finance offers quick access to capital, it comes with limitations and potential criticisms. The primary drawback for issuers is that the implied interest rate can be higher than traditional loans, especially for entities with lower credit ratings, due to the inherent risk premium demanded by investors. The reliance on short-term instruments can also expose issuers to rollover risk, where they might struggle to find new investors or face significantly higher costs when existing instruments mature.

Historically, the commercial paper market, a key component of discount finance, has seen periods of significant contraction and expansion, reflecting shifts in market conditions and investor confidence. For instance, the market experienced a persistent downtrend in outstanding commercial paper during 1920-1932, and while it has grown significantly since then, it remains a smaller component of the overall money market.² Furthermore, incidents of commercial paper defaults, such as those that began in 1989, have led to tighter regulations and increased scrutiny on credit quality, prompting investors to reduce exposure to medium-quality paper.¹ These events underscore the importance of investor due diligence and the potential for market instability in discount finance instruments.

Discount Finance vs. Commercial Paper

While closely related, "discount finance" is a broader concept, and "commercial paper" is a specific type of instrument that often utilizes discount finance.

Discount Finance: This is a method of raising capital by selling an asset or debt instrument at a price below its face value. It applies to various financial instruments, including Treasury bills, certain bonds, and even the sale of receivables. The core idea is that the return to the investor comes from the difference between the discounted purchase price and the full face value received at maturity.
Commercial Paper: This is a specific type of short-term debt instrument issued by large corporations and financial institutions. It is typically unsecured and sold at a discount to its face value, maturing within 270 days. Commercial paper is a prime example of discount finance in action, as the issuer receives discounted funds upfront and repays the full face value at maturity.

The confusion arises because commercial paper is one of the most prominent and frequently cited examples of discount finance. However, not all discount finance involves commercial paper, and commercial paper's defining characteristic is its short-term, unsecured nature, often, but not exclusively, issued at a discount.

FAQs

What does "sold at a discount" mean?

When an instrument is "sold at a discount," it means the buyer pays less than the final amount they will receive when the instrument matures. For example, if you buy a $100 bond for $95, it's sold at a discount. The $5 difference is the return you expect to earn.

Why do companies use discount finance?

Companies use discount finance primarily to raise quick, short-term debt for operational needs. It can be a flexible alternative to traditional bank loans, especially for large, creditworthy firms that can access the money market directly. It helps manage working capital efficiently.

Is discount finance risky for investors?

The risk for investors in discount finance depends heavily on the issuer's credit rating and the specific instrument. Highly rated instruments like Treasury bills carry very low risk. However, commercial paper from less creditworthy companies can carry higher default risk, meaning the issuer might not be able to repay the face value at maturity.

How does discount finance differ from a loan with interest?

With a traditional loan, you borrow a principal amount and then make periodic interest payments on that principal, eventually repaying the principal itself. In discount finance, you receive an amount less than the final repayment amount upfront. The "interest" or cost is embedded in the difference between what you receive initially and what you pay back at the maturity date. This embedded cost is effectively the discount rate or implied yield. It's similar to calculating the present value of a future payment.