Final answer:
The discount yield differs from the T-bill's bond equivalent yield because the former is based on the purchase price and face value without accounting for compounding, while the latter includes the time value of money and assumes the proceeds can be reinvested at the same rate.
Step-by-step explanation:
The discount yield differs from the T-bill's bond equivalent yield (BEY) because they use different methods for calculating the yield of a bond. The discount yield (also known as the bank discount yield) is calculated based on the bond's purchase price and its face value, while not accounting for compounding. On the other hand, the bond equivalent yield takes into account the time value of money by annualizing the yield based on a 365-day year, which allows for comparison to other bonds with different payment frequencies.
For example, consider a T-bill with a face value of $1,000, a purchase price of $970, and a maturity of 180 days. The discount yield would focus on the $30 discount and express it as a percentage of the face value, annualized based on a 360-day year. The bond equivalent yield, however, would annualize based on a 365-day year and would include the effect of compounding, assuming the proceeds could be reinvested at the same rate.
Because corporate bonds often come with higher interest rates due to the inherent risk compared to Treasury bonds, this difference in yield calculation methods is important for investors comparing an investment in corporate bonds versus Treasury bills. While corporate bonds typically offer higher returns to compensate for their higher risk, T-bills provide a lower but more secure return, often higher than traditional bank accounts.