SAIM2220 - Interest: specific inclusions: discounts

Discounts and premiums

Paying interest is only one way in which a borrower may ‘reward’ a lender. Debt securities, such as government or corporate bonds, may be issued at a discount. For example, a 5-year bond may have a nominal value of £1,000, but be issued for £800. When the investor redeems the bond at maturity, he or she will receive £1,000 - the £200 profit, or ‘original issue discount’, represents the investor’s reward for lending. A security that is issued at a discount may carry interest as well, or it may be interest-free (a zero coupon bond).

A third way of rewarding an investor is by redeeming the security at a premium. The nominal value of the security is, say, £800, and any interest is calculated on a principal amount of £800, but when the security matures the investor will get back (say) £1,000.

But many investors will – rather than subscribing for a security and then holding it to maturity – buy and sell securities in the market. The difference between the purchase price and the face value of the security is called ‘market discount’.