Money Markets: Interest and Discount

In money markets, return is either in the form of income or capital.

The one exception to this rule is the certificate of deposit (CD) which, although interest-bearing, can, if sold in the secondary market, also produce a capital gain.

If the return is in the form of income, the instrument is issued at a discount to face value and redeemed at face value at maturity.

Convention dictates that some instruments provide a return in the form of income - interest bearing instruments - and some in the form of capital - discount securities. In general, deposits and loans, certificates of deposit and some commercial paper issues are interest bearing, and all other instruments - Treasury bills, bankers’ acceptances and most commercial paper - are discount securities.

Money market instruments, whether they are interest bearing or discount, are priced in terms of the annualised percentage return they offer. However, the way return is measured differs between the two types of instrument.

Interest bearing instruments provide a rate of return or yield.

• A rate of return measures the return on a cash money market instrument as an annualised percentage of its proceeds; that is, an annualised percentage of the cash paid for the instrument.

Discount securities provide a rate of discount.

• A rate of discount measures the return on an instrument as an annualised percentage of its face value; that is, the difference between the cash paid for the instrument and its redemption value as an annualised percentage of its face value.

How then do we calculate and compare these two types of return? We will begin by looking at interest bearing instruments.