Money market rates: discount basis and add-on basis
Money market rates are simple annual rates, not compounded. T-bills, commercial paper and bankers' acceptances are quoted on a discount basis: interest is taken off the face value. Certificates of deposit (CDs), repos and reference rates use an add-on basis: interest is added to the amount invested.
Before this: Yield and Yield Spread Measures for Fixed-Rate Bonds, Bond Valuation: Prices and Yields
On the exam
- Calculate and interpret yield measures for money market instruments
Calculate and interpret yields on money market instruments. Expect to price a bill from a discount rate, find a deposit's redemption amount from an add-on rate, and explain why a discount rate understates the return.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What makes money market yields different from bond yields?
Money market instruments are debt securities with original maturities of one year or less. They include Treasury bills (government securities issued for a year or less), commercial paper , certificates of deposit (CDs), bankers’ acceptances , repurchase agreements and time deposits tied to market reference rates. Money market mutual funds hold these instruments and are sometimes used as an alternative to bank deposits.
A bond yield to maturity is annualized and compounded. Money market yields work differently in three ways.
- Simple interest Memorize annualized, not compounded
- Periodicity varies Memorize Year ÷ Days, so it changes with maturity
- Non-standard quotes Memorize discount or add-on, with their own pricing formulas
- Simple interest. The rate is annualized but not compounded.
- Periodicity changes with maturity. A bond yield has one periodicity for every maturity, such as 2. A money market rate has periodicity , so a 30-day rate and a 180-day rate annualize differently.
- Non-standard quotes. Many instruments are quoted as a discount rate or an add-on rate, and need their own pricing equations rather than the usual bond calculation.
Quoted rates are of two kinds, and the instrument tells you which.
- Discount rate Memorize interest as a share of face value; the quoted amount is the face value at maturity
- Treasury bills government, under one year
- Commercial paper corporate
- Bankers' acceptances bank-guaranteed trade paper
-
- Add-on rate Memorize interest as a share of the amount invested; the quoted amount is the price at issue
- Certificates of deposit bank deposits
- Repurchase agreements repos
- Market reference rates the rate indexes
-
Try this 0 of 3
- Discount basis: stretch the bill to 360 days or more
- Discount basis: raise the rate to 8% or more
- Add-on basis: switch the CD to a 360-day year
The 4.20% discount rate understates the return: the investor pays USD 4,930,000 and earns USD 70,000, which is 4.319% on a 365-day add-on basis (12 bps more).
Quoted this way: Treasury bills, commercial paper and bankers' acceptances. The quote names the face value.
Show working
Price = FV × (1 − Days/Year × DR) = 5,000,000 × (1 − 120/360 × 0.042) = USD 4,930,000.00
Interest = 5,000,000 − 4,930,000.00 = USD 70,000.00. Check: DR = (360/120) × 70,000.00 ÷ 5,000,000 = 4.20%, measured against face value.
Return on the money invested (365-day add-on) = (365/120) × 70,000.00 ÷ 4,930,000.00 = 4.319%
- 120÷360×0.042=+|-+1=×5000000=price 4,930,000.00
- STO1
- 5000000−RCL1=interest 70,000.00
- ÷RCL1×365÷120=0.043188, the 365-day add-on return
+|- change sign · STO store · RCL recall a stored number
- 1ENTER120ENTER360÷0.042×−5000000×price 4,930,000.00
- STO1
- 5000000x<>y−interest 70,000.00
- RCL1÷365×120÷0.043188, the 365-day add-on return
ENTER enter (on the HP, puts the number on the stack) · STO store · x<>y swap the last two numbers · RCL recall a stored number
How does the discount basis work?
In the money market, the discount rate has a special meaning. The interest is built into the face value: you pay less than face value today and receive the face value at maturity. The rate is the interest as a share of the face value, annualized.
Here PV is the present value (the price you pay) and FV is the future value (the face value). The year is 360 or 365 days depending on the market, so always read it from the question.
Rearranging the formula gives the discount rate from a price. The first term, , is the periodicity. The second is the interest divided by the face value.
A 120-day bill with face value 5,000,000.00 is quoted at a 4.20% discount rate on a 360-day year. Its price is closest to:
5,000,000.00 × (1 − 120/360 × 0.042) = 4,930,000.00
Price, PV4,930,000.00
- 120÷360×0.042=+|-+1=×5000000=4,930,000.00
+|- change sign
- 120ENTER360÷0.042×CHS1+5000000×4,930,000.00
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
Why a discount rate understates the return
The denominator is the face value, USD 5,000,000, and not the USD 4,930,000 the investor actually paid. Interest of USD 70,000 on the money invested is a bigger percentage than on the face value, so the quoted rate is too low. The same is true from the other side: for the issuer, a discount rate understates the cost of the money borrowed.
How does the add-on basis work?
An add-on rate is a simple interest rate on the amount invested. You put in the principal today and receive the principal plus interest at maturity.
Rearranging gives the price of a deposit that pays a known amount, and the rate from a price.
An investor places 12,000,000.00 in a 150-day deposit at a 4.60% add-on rate on a 365-day year. The amount received at maturity is closest to:
12,000,000.00 × (1 + 150/365 × 0.046) = 12,226,849.32
Amount at maturity, FV12,226,849.32
- 150÷365×0.046+1=×12000000=12,226,849.32
- 150ENTER365÷0.046×1+12000000×12,226,849.32
ENTER enter (on the HP, puts the number on the stack)
The two quotes line up like this.
| Discount rate | Add-on rate | |
|---|---|---|
| Formula | ||
| Interest is divided by | face value | amount invested |
| Quoted amount | face value at maturity | price at issue |
| Typical instruments | T-bills, commercial paper, bankers’ acceptances | CDs, repos, market reference rates |
Exam tip Read the instrument first. Bill, paper or acceptance: discount formula. Deposit, repo or reference rate: add-on formula.
Go deeper Why 360-day years are still used
Many money market quotes use a 360-day year, a convention that began when calculations were done by hand and has stayed. Some markets use 365 days. The year in a question is part of the quote, so use the year given. The difference matters mostly when you compare instruments, which is why the next lesson restates everything on a 365-day basis.
Go deeper Money market funds as a deposit alternative
A money market mutual fund holds only eligible money market securities, so its return comes from the short-dated discount and add-on instruments above. Investors sometimes treat it as a substitute for a bank deposit.
Memorize this
MemorizeDiscount rate against add-on rate
| Discount rate | Add-on rate | |
|---|---|---|
| Formula | ||
| Divides interest by | face value | amount invested |
| Quoted amount | face value at maturity | price at issue |
| Instruments | T-bills, commercial paper, bankers' acceptances | CDs, repos, reference rates |
Memory hook Discount: the face value is the denominator. Add-on: the money you put in is the denominator.
Know it cold Face value is bigger than the price paid, so a discount rate is smaller than the true return: it understates it.
MemorizePrice and redemption formulas
Memory hook Discount quotes shrink the face value; add-on quotes grow the principal. Both multiply the annual rate by Days ÷ Year first.
Know it cold and . Never mix the two.
MemorizeWhat makes the money market different
Memory hook Simple, short, odd: simple interest, short maturities, odd quotes.
Know it cold Maturity is one year or less. Rates are annualized, not compounded; periodicity is Year ÷ Days.
- Discount rate Memorize interest as a share of face value; the quoted amount is the face value at maturity
- Treasury bills government, under one year
- Commercial paper corporate
- Bankers' acceptances bank-guaranteed trade paper
-
- Add-on rate Memorize interest as a share of the amount invested; the quoted amount is the price at issue
- Certificates of deposit bank deposits
- Repurchase agreements repos
- Market reference rates the rate indexes
-
- Simple interest Memorize annualized, not compounded
- Periodicity varies Memorize Year ÷ Days, so it changes with maturity
- Non-standard quotes Memorize discount or add-on, with their own pricing formulas
Quick example
A 182-day bill with face value 2,000,000 at a 3.90% discount rate (360-day year): 2,000,000 × (1 − 182/360 × 0.039) = 1,960,567.
- 182÷360×0.039=+|-+1=×2000000= 1960566.67
+|- change sign
- 182ENTER360÷0.039×CHS1+2000000× 1960566.67
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
Quick example
A 126-day bill with face value 8,000,000 costs 7,900,000 (360-day year): 360/126 × 100,000 ÷ 8,000,000 = 3.571%.
- 8000000−7900000=÷8000000×360÷126= 0.035714
- 8000000ENTER7900000−8000000÷360×126÷ 0.035714
ENTER enter (on the HP, puts the number on the stack)
Quick example
30,000,000 placed for 270 days at a 4.20% add-on rate (365-day year): 30,000,000 × (1 + 270/365 × 0.042) = 30,932,055.
- 270÷365×0.042+1=×30000000= 30932054.8
- 270ENTER365÷0.042×1+30000000× 30932054.8
ENTER enter (on the HP, puts the number on the stack)
Quick example
A deposit will pay 5,000,000 in 60 days. At a 3.00% add-on rate (365-day year) it is worth 5,000,000 ÷ (1 + 60/365 × 0.03) = 4,975,463.
- 60÷365×0.03+1=1/x×5000000= 4975463.47
1/x reciprocal
- 60ENTER365÷0.03×1+1/x5000000× 4975463.47
ENTER enter (on the HP, puts the number on the stack) · 1/x reciprocal
Quick example
A 270-day deposit of 30,000,000 pays back 30,900,000 (365-day year): 365/270 × 900,000 ÷ 30,000,000 = 4.056%.
- 30900000−30000000=÷30000000×365÷270= 0.040556
- 30900000ENTER30000000−30000000÷365×270÷ 0.040556
ENTER enter (on the HP, puts the number on the stack)
How it is asked
-
Price a bill from its discount rate
75-day bill, face 4,000,000, DR 3.60%, 360-day year.
4,000,000 × (1 − 75/360 × 0.036) = 3,970,000. Trap: 3,856,000 (full annual rate), 3,970,223 (add-on formula).
-
Redemption amount from an add-on rate
135-day CD, 15,000,000, AOR 2.90%, 365-day year.
15,000,000 × (1 + 135/365 × 0.029) = 15,160,890. Trap: 360-day year (15,163,125).
-
Why does a discount rate understate the return?
Choose the reason.
It divides interest by the face value, not the smaller price paid.
-
Discount rate from a price
Face 8,000,000, price 7,900,000, 126 days, 360-day year.
360/126 × 100,000 ÷ 8,000,000 = 3.57%. Trap: dividing by the price gives 3.62%.
Exam traps
- Using the add-on formula for a discount-quoted bill, or the discount formula for a CD.
- Mixing 360- and 365-day years. Use the year basis the quote states.
- Forgetting to prorate the annual rate by Days ÷ Year: a 90-day bill does not earn the full annual rate.
- Reading a discount rate as the investor's return. It understates it, because interest is divided by the face value.
Checkpoint
5 exam-style questions. About 90 seconds each.
1A 90-day bill with face value USD 1,000,000 is quoted at a 3.80% discount rate (360-day year). Its price is closest to:
2An investor places EUR 25,000,000 in a 182-day CD at a 3.20% add-on rate (365-day year). The amount received at maturity is closest to:
3A money market discount rate understates the investor's rate of return because the interest earned is divided by:
4A 91-day bill with face value 10,000,000 is bought for 9,900,000. On a 360-day year, its discount rate is closest to:
5Which money market instrument is most likely quoted on an add-on rate basis?
Key takeaways
- Money market rates are simple, annualized and not compounded; periodicity = Year ÷ Days.
- Discount basis: PV = FV × (1 − Days/Year × DR). It understates the return.
- Add-on basis: FV = PV × (1 + Days/Year × AOR).
- T-bills, commercial paper and bankers' acceptances use discount; CDs, repos and reference rates use add-on.
Quick example
A 182-day bill with face value 2,000,000 at a 3.90% discount rate (360-day year): 2,000,000 × (1 − 182/360 × 0.039) = 1,960,567.
- 182÷360×0.039=+|-+1=×2000000= 1960566.67
+|- change sign
- 182ENTER360÷0.039×CHS1+2000000× 1960566.67
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
Quick example
A 126-day bill with face value 8,000,000 costs 7,900,000 (360-day year): 360/126 × 100,000 ÷ 8,000,000 = 3.571%.
- 8000000−7900000=÷8000000×360÷126= 0.035714
- 8000000ENTER7900000−8000000÷360×126÷ 0.035714
ENTER enter (on the HP, puts the number on the stack)
Quick example
30,000,000 placed for 270 days at a 4.20% add-on rate (365-day year): 30,000,000 × (1 + 270/365 × 0.042) = 30,932,055.
- 270÷365×0.042+1=×30000000= 30932054.8
- 270ENTER365÷0.042×1+30000000× 30932054.8
ENTER enter (on the HP, puts the number on the stack)
Quick example
A deposit will pay 5,000,000 in 60 days. At a 3.00% add-on rate (365-day year) it is worth 5,000,000 ÷ (1 + 60/365 × 0.03) = 4,975,463.
- 60÷365×0.03+1=1/x×5000000= 4975463.47
1/x reciprocal
- 60ENTER365÷0.03×1+1/x5000000× 4975463.47
ENTER enter (on the HP, puts the number on the stack) · 1/x reciprocal
Quick example
A 270-day deposit of 30,000,000 pays back 30,900,000 (365-day year): 365/270 × 900,000 ÷ 30,000,000 = 4.056%.
- 30900000−30000000=÷30000000×365÷270= 0.040556
- 30900000ENTER30000000−30000000÷365×270÷ 0.040556
ENTER enter (on the HP, puts the number on the stack)
All Fixed Income formulas, every lesson
Practice exam-style questions on Yield and Yield Spread Measures for Floating-Rate Instruments
Questions about this lesson?
Where this comes back
- Term Structure: Spot, Par and Forward Curves Fixed Income
- Monetary Policy Economics
Questions candidates ask
How do you price a Treasury bill from its discount rate?
Multiply the face value by one minus the discount rate times days over the year basis. A 75-day bill at 3.60% on a 360-day year costs 1 − 75/360 × 0.036 = 99.25% of face value.
What is an add-on rate?
A simple interest rate applied to the amount invested. The interest is added to the principal at maturity, so FV = PV × (1 + Days/Year × AOR).
Why does a discount yield understate the return?
It measures interest against the face value, which is larger than the amount actually invested. Dividing by the smaller price gives the true return.
Which instruments use which quote?
Treasury bills, commercial paper and bankers' acceptances usually use discount rates. Certificates of deposit, repos and market reference rates use add-on rates.
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