Money, Banking, and International Finance

discount bond is a Treasury Bill issued by the U.S. government. For this example, the Treasury
Bill has a face value of $10,000, which we call T-bills for short. Discount bonds do not have an
interest rate listed on them. Thus, U.S. government sells T-bills at a discount or lower price.
Lower price reflects the market interest rate.

Treasury Bill

U.S. Government

$10,000

August 10, 2013

Figure 2. A picture of a Treasury Bill

For example, if the U.S. federal government sold this T-bill to you for $9,500, then the
present value, PV 0 , becomes the market price. Subsequently, the federal government will repay
you $10,000 for this instrument on August 10, 2013. The $500 difference reflects the interest on
this loan.
Investors and analysts calculate the yield to maturity (YTM), the return to an investment.
Yield to maturity reflects an investor’s profit from a security that is similar to an interest rate.
We state both interest rates and yield to maturity in annual percentage terms. For our example,
we calculated the yield to maturity of 5.26% in Equation 1 if the bond’s face value equals
$10,000 while the market value is $9,500 with a maturity of one year.

 

 

0. 0526

9,500

10000

1

1

10000

9,500

1

YTM=

$

$ ,

+YTM=

+YTM

$ ,

$ =

+YTM

FV

PV 0 =^1

( 1 )

If a discount bond has a maturity less than one year, then the time subscript remains one
year. However, we adjust the yield to maturity to annual terms. For example, if the T-bill in the
previous example matured in 180 days, then we calculate it in the same way. Nevertheless, we
multiply the rate of return by two because 365 days divided by 180 is approximately two. In our
case, the return would equal 10.52%.
Discount bonds usually have a maturity of one year or less. However, we can adjust the
present value formula to calculate bonds with longer maturities. For example, you purchased a