Jump-Diffusion Models for Valuing the Future: Discounting under Extreme Situations

Jaume Masoliver, Miquel Montero and Josep Perelló
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Jaume Masoliver: Departament de Física de la Matèria Condensada, Universitat de Barcelona, 08028 Barcelona, Spain
Miquel Montero: Departament de Física de la Matèria Condensada, Universitat de Barcelona, 08028 Barcelona, Spain
Josep Perelló: Departament de Física de la Matèria Condensada, Universitat de Barcelona, 08028 Barcelona, Spain

Mathematics, 2021, vol. 9, issue 14, 1-26

Abstract: We develop the process of discounting when underlying rates follow a jump-diffusion process, that is, when, in addition to diffusive behavior, rates suffer a series of finite discontinuities located at random Poissonian times. Jump amplitudes are also random and governed by an arbitrary density. Such a model may describe the economic evolution, specially when extreme situations occur (pandemics, global wars, etc.). When, between jumps, the dynamical evolution is governed by an Ornstein–Uhlenbeck diffusion process, we obtain exact and explicit expressions for the discount function and the long-run discount rate and show that the presence of discontinuities may drastically reduce the discount rate, a fact that has significant consequences for environmental planning. We also discuss as a specific example the case when rates are described by the continuous time random walk.

Keywords: stochastic processes; finance; climate; discount function; environmental econonomics; Poissonian jumps; Ornstein–Uhlenbeck process; interest rates; asymptotics (search for similar items in EconPapers)
JEL-codes: C (search for similar items in EconPapers)
Date: 2021
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