Discount Rate

A borrower's loan agreement adjusts with the prime rate. Who sets the prime rate?

1. A.The Federal Open Market Committee, at each of its regularly scheduled meetings.Wrong. The FOMC sets a target for the federal funds rate and publishes no lending rate for bank customers.
2. B.Commercial banks, as the rate charged to their most creditworthy customers.Correct. Prime is a benchmark each bank sets for its best commercial borrowers, and it follows the Fed's policy stance.
3. C.The Board of Governors, as a ceiling on what banks are permitted to charge.Wrong. The Board sets reserve requirements and approves discount rates; it does not cap what banks may charge.
4. D.The Treasury, as part of its management of federal government borrowing costs.Wrong. The Treasury borrows money and manages federal debt, playing no part in setting bank lending rates.

Why: The prime rate is a commercial bank rate, quoted by banks for their strongest borrowers and used as a reference for many floating-rate loans. Banks move it in response to the Fed's policy stance, because the cost of the reserves funding those loans tracks the federal funds market. That relationship is why prime rises after a tightening and falls after an easing, but the decision belongs to the banks themselves. The Fed's own rates are the discount rate it charges banks and the federal funds target it steers toward.

The Federal Reserve's discount rate is:

1. A.The rate banks charge their best customersThis is the prime rate, set by commercial banks for their most creditworthy borrowers. The prime rate tends to follow Fed policy, but the discount rate is the rate the Fed itself charges banks.
2. B.The inflation rateInflation is an economic outcome the Fed tries to influence, not a rate it charges anyone. The discount rate is one of the policy levers used to pursue the inflation objective.
3. C.The rate the Fed charges banks for short-term loansCorrect - the discount-window rate.
4. D.The rate on Treasury billsT-bill yields are set by auction in the open market, reflecting investor demand rather than an administered decision. The discount rate is set administratively by the Fed for direct lending to banks.

Why: The discount rate is the interest rate the Fed charges banks for short-term loans.

The internal rate of return (IRR) is:

1. A.The risk-free rateThe risk-free rate is an external market benchmark, typically a Treasury yield, used to judge whether an IRR is attractive. IRR is computed from the investment's own cash flows and varies with them.
2. B.The inflation rateInflation is an economy-wide price measure, not a property of any one investment's cash flows. Subtracting inflation from IRR gives a real return, which shows the two are distinct quantities.
3. C.The discount rate that makes NPV equal zeroCorrect - IRR is the NPV-zero rate.
4. D.The coupon rateA bond purchased at par and held to maturity does produce an IRR equal to its coupon, which is where this gets its plausibility. That is a coincidence of one special case: IRR is generally defined as the rate that drives net present value to zero, for any pattern of cash flows.

Why: IRR is the discount rate at which an investment's net present value equals zero.

A positive net present value (NPV) indicates that an investment's:

1. A.Risk is zeroNPV says nothing about the level of risk; risk enters through the discount rate chosen. A risky project can show a positive NPV precisely because it was discounted at a high required return and still cleared it.
2. B.Expected return exceeds the required discount rateCorrect - positive NPV adds value.
3. C.Return is negativeThis reads the sign backwards. Positive NPV means the discounted cash inflows exceed the cost, so the project earns more than the required rate.
4. D.Return equals inflationMatching inflation is a break-even in purchasing power, not the benchmark NPV tests against. NPV compares the return to the required discount rate, and clearing it by any margin makes NPV positive.

Why: A positive NPV means the expected return exceeds the required discount rate, adding value.