Treasury bills are a short-term investment option for investors seeking security and stability. The United States Treasury sells Treasury bills at a discount, with prices quoted as a percentage of the face, or maturity, value. This discount represents the difference between what the investor pays for the Treasury bill and its value at maturity. The bank discount method is the primary method used for calculating the interest earned on the investment.
The U.S. Treasury issues Treasury bills in three-month, six-month and 12-month periods. Calculated as weeks, these are 13-week, 26-week and 52-week periods. The U.S. Treasury sells three-month and six-month T-bills via auction. The income, or yield, you receive as an investor is the difference between the T-bill's auction price and its face value. With T-bills, you do not receive interest payments; the discount includes the yield you earn if you hold the T-bill until it matures. You calculate T-bill yields using the bank discount method.
Bank Discount Method
To use the bank discount method, you first deduct the purchase price from the face value. Divide the resulting number by the face value. Then divide 360 days by the number of days until the T-bill matures. Finally, multiply the first total by the second total. This provides the bank discount rate as a percentage.
The auction purchase price on a six-month T-bill is $97.495 per $100 of face value. You purchase the T-bill when it still has 180 days before maturity. The discount is $100 less $97.995 or $2.505. The discount divided by the face value is $2.005 divided by $100 or .02505, which is 2.505 percent. Divide 360 days by 180 days -- there are two six-month periods in a year -- to get two. Multiply 2.505 percent by two. The yield estimate is 5.01 percent.
Difference in Yield
The bank discount method does not factor in compounding interest. In addition, the formula uses 360 days instead of the actual 365 or 366 days in a year. Therefore, the discount rate you calculate will be lower than the actual yield you receive on your T-bill. The bank discount method is useful, however, for providing an excellent approximation of the yield you will receive.
Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.