How to Convert Interest Rates to Discount Rates

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By John Gugie
eHow Contributing Writer

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The term "discount rate" can mean a few different things depending on the level of the investment. More experienced users use the term "discount rate" to calculate present value, such as net present value or discounted cash flow. For general use by most the population, the term "discount rate" is used as the annual effective discount rate, which is an interest rate that takes into account the capital paid to get the interest as return after the investment instrument matures. The annual effective discount rate is simply the annual interest divided by the capital used to get the interest and the interest itself. This rate is lower than the interest rate because it gives investors the investment value after a year as a nominal value, or money value before inflation adjustment. This data amount is used for financial instruments, such as Treasury bills or bonds. Investors use the discount rate to determine the rate of return that could be earned on investments with similar risk calculated as present value. For this guide's example, suppose that a Treasury bond sells for $100 and pays the buyer $110 at the end of the year.

Difficulty: Moderately Easy

Instructions

Things You'll Need:

Calculator
Investment data

Step 1

Calculate the interest rate if it is not already known. Use the formula, r = I/Pt, to calculate the interest rate where "r" is the interest rate, "I" is the interest amount, "P" is the principal amount and "t" is the duration of time until the maturity of the bond. In the example, r = 10/100x1 = 10/100 = .10 or 10%.
Step 2

Calculate the discount rate using the interest rate from Step 1. Use the formula, d = i / (1 + i), to calculate the discount rate with a known interest rate. "d" is the discount rate and "i" is the interest rate. In the example, d = .10 / (1 + .10) = .10 / 1.10 = .09 or 9%.
Step 3

Double-check the calculation by calculating the interest rate using the discount rate found in Step 2. Use the formula, i = d / (1 - d), where "i" is the interest rate and "d" is the discount rate. In the example, i = .09 / (1 - .09) = .09 / .91 = .099 or rounded up 10%.