Discount margin is the return earned above a benchmark rate for floating rate securities, with the actual amount depending on the security’s price compared to the reference rate. It can start at zero and increase over time, but rarely falls into negative figures. Investors use it to set reasonable expectations for returns and evaluate the purchase of floating rate securities.
A discount margin is the amount of return earned above a specific benchmark rate associated with some type of floating rate security. The actual amount of the margin depends on the price of the security on a given date and how that price compares to the reference rate. Projecting the discount margin over the life of the floating rate or security note is useful to investors because it sets reasonable expectations for the amount of return that will be realized from point of sale to maturity date.
Depending on the current state of the security price, the discount margin may start at zero and increase from that point. Only in very unusual circumstances would the margin fall into a negative figure. This is especially true with bonds, which often ensure that even if the investor doesn’t make any money from the investment, they at least get back the original purchase amount of the bond issue.
A discount margin can be zero when the current price is the same as the reference rate. This essentially means that up to that point, the asset has not gained anything beyond the anticipated growth rate. It is not unusual for a floating rate security to experience this phenomenon early in the asset’s life. As time passes, there are more opportunities for the discount margin to deviate from the benchmark rate as the security price begins to rise.
It is important to note that the price movement of the float or float security affects the amount of the discount margin. This means that during the life of the security, there may be periods when the margin is higher than at other times. Should events occur that lower the float price after a period of increase, the discount margin will be adjusted accordingly.
Investors consider the discount rate when evaluating the purchase of a floating rate security. By allowing for the probability that the rate will change over the life of the security, it is possible to determine what is considered the most likely price development of the security. In case the performance is higher than this norm or established reference, then the discount margin increases. Investors often look for signs that upcoming market trends may trigger this type of response, making it possible for them to ultimately earn more from the investment than originally anticipated.
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