Rare Disasters, Tail-Hedged Investments, and Risk-Adjusted Discount Rates

Martin Weitzman

No 18496, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: 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.

JEL-codes: E43 G11 G12 Q54 (search for similar items in EconPapers)
Date: 2012-10
New Economics Papers: this item is included in nep-ene, nep-mac and nep-ppm
Note: EEE
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (33)

Downloads: (external link)
http://www.nber.org/papers/w18496.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:nbr:nberwo:18496

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w18496

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by ().