Rare Disasters, Tail-Hedged Investments, and Risk-Adjusted Discount Rates / Martin L. Weitzman.

Format:

Book

Author/Creator:

Weitzman, Martin L.

Contributor:

National Bureau of Economic Research.

Series:

Working Paper Series (National Bureau of Economic Research) no. w18496.

NBER working paper series no. w18496

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2012.

Summary:

What is the best way to incorporate a risk premium into the discount rate schedule for a real investment project with uncertain payoffs? The standard CAPM formula suggests a beta-weighted average of the return on a safe investment and the mean return on an economy-wide representative risky investment. Suppose, though, that the project constitutes a tail-hedged investment, meaning that it is expected to yield positive payoffs in catastrophic states of nature. Then the model of this paper suggests that what should be combined in a weighted average are not the two discount rates, but rather the corresponding two discount factors. This implies an effective discount rate schedule that declines over time from the standard CAPM formula down to the riskfree rate alone. Some simple numerical examples are given. Implications are noted for discounting long-term public investments and calculating the social cost of carbon in climate change.

Notes:

Print version record

October 2012.