How to Calculate Discount Margin

The discount margin is the additional return earned beyond earnings based on index when a floating rate bond matures. The discount margin, essentially, is how much additional money an investor can earn by purchasing a security that has a higher risk due to an adjustable interest rate. If the investor gets a "good deal," the discount margin will be higher than if he or she purchased a less risky, standard bond. The amount of the discount margin depends on several factors.

Factors Affecting Discount Margin

  • Floating rate - Discount margins only exist when bonds are offered at a reduced price. This happens on securities with floating rates. The floating rate adjusts based on a market indicator, such as the S&P 500, and it goes up and down during the security's lifetime. Not all bonds have floating rates. Those that do present this option to partly compensate for inflation, since the floating rate should counteract the threat of inflation.
  • Reset margin - In addition to the rate that floats with the underlying index, the security will have a reset margin. For example, the note may be purchased at .75 percent over the S&P 500. The floating rate goes up and down with the S&P 500, and the reset margin stays a consistent amount higher than this floating rate.
  • Discount price - This is the price paid for the security. Since the rates bounce around, the investor is uncertain of his or her eventual profit. For this reason, the price for a floating rate note is lower than the price for other standard notes, and the yield may also be lower.
  • Par value - This is the current market value of the security. At the time of maturity, the value of a bond often converges to par. 

Calculating Discount Margin

Floating rate notes are sold below par value. Therefore, there is a potential to generate additional return on the note at the time it is sold. Considering the main factors listed above, there are three main scenarios to calculate discount margin.

  1. Negative discount margin - Unfortunately, there will be times when the price paid for the discount bond is actually above the par value at the time of maturity. In this case, the difference between the discount price and the par value would be subtracted from the reset margin to determine the decreased discount margin.
  2. Zero discount margin - When the price an investor paid for a floating rate note equals the par value when the bond matures, no additional return is generated. The discount rate is equal to the reset margin on the note.
  3. Positive discount return - This is the scenario a person purchasing a discount bond hopes for. Here, the discount price an investor paid for a floating rate note is beneath the current par value at the time of maturity. The difference between the discount price and the par value provides additional return. To calculate discount margin, add this return to the reset margin. The discount margin will be above the margin the investor would have earned by purchasing a standard note.
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