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As discussed in LI 6.3, the market interest rate of a financial instrument depends on a number of factors, including the risk-free interest rate, credit risk, and liquidity. When an asset does not provide a coupon equal to the rate demanded by market participants, a loan or security may be issued at a discount or premium. Normally, the market price of a debt instrument is equal to the present value of its future cash flows discounted at the rate of return demanded by market participants.
Discounts and premiums are the difference between the amount paid upon acquisition of a financial asset and the amount repayable at its maturity (or in scheduled principal payments made over its life). Discounts occur when a financial asset is purchased for an amount less than the par amount of an instrument and are typically seen when the coupon on the investment is less than the market yield for that instrument. Premiums arise when a financial asset is purchased for an amount greater than the par amount of an instrument and are typically seen when the coupon on the instrument is higher than the market yield for that instrument.
The difference between the purchase price of an investment and the amount to be repaid at maturity (the premium or discount) coupled with any coupon interest received over the instrument's life determine the investor's yield on its investment. If a debt instrument is originated or purchased at a discount, the effective interest rate on the instrument will be higher than the stated rate. Conversely, if a debt instrument is originated or purchased at a premium, the effective rate is lower than the stated rate.
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