Discount Margin is the return earned on a floating rate bond beyond the earnings based on the reference rate of that security.

The reference rate is an interest rate benchmark used to set other interest rates. The most common reference rate benchmarks include T-bills, Fed Funds Rate, LIBOR, commercial papers, and bankers’ acceptances.

Simply, in calculating the discount margin, investors compare the price of a fixed-rate bond with the current interest rate of a floating-rate note. The rate above the return of a fixed-rate bond that an investor would benefit from by taking an extra risk with a floating rate note is a discount margin.

The calculation of discount margin involves seven variables:

P= floating rate notes price plus any accrued interest

c(i)= cash flow received at the end of the time period i ( for the final period n, the principal amount must be included)

I(i)= the assumed index level at the time period i

I(1)= the current index level

d(S)= the number of days from the start of the time period until the settlement date

DM= the discount margin

Discount Margin is also known as the required margin is the spread demanded by the market

Floating-rate notes objective is to protect investors from volatile interest rates. The coupon rate on floating-rate notes is not just a reference rate but even consists of certain numbers denoted in basis points, termed as a spread that gets added to the reference rate.

The specific yield spread over the reference rate is called as quoted margin.

For example, YYZ company rated A2 issued a floating rate bond with coupon rate 6-month T-Bill + 240 bps. The 2.4% or 240 bps is the reflection of its credit quality.

The coupon rate of floating rate note = reference rate + quoted margin

What happens if the floating-rate notes credit risk changes and investors demand an additional return to bear the risk?

Thus, the required margin/discount margin is the additional spread over the reference rate such that the floating-rate note is priced at par on a rate reset date.

For example, A floating-rate note has a coupon rate of a 3-month T-bill plus 50 bps. 5 months after the issuance the issuer’s credit rating downgrades and the market demands a required spread of 75 bps. The coupon rate of floating-rate notes is lower than the market required rate. As the result, the floating rate note would be priced at a discount to par

Similarly, if the creditworthiness of the issuer improves the required margin goes below quoted margin and the market will demand a lower spread.

The discount margin will be the difference between the required margin and quoted margin.

However, in calculating a discount margin investors compare the price of a fixed bond with the current interest rate of the floating-rate note.

Reference used: https://www.investopedia.com/terms/d/discountmargin.asp

Cover image reference: https://img.freepik.com/premium-photo/businessman-hand-touching-virtual-percentage-icon-discount-percentage-concept_35148-6993.jpg