Discounting Damage Awards Using the Zero Coupon Treasury Curve: Satisfying Legal and Economic Theory While Matching Future Cash Flow Projections

How to calculate damage awards has long been the subject of academic dispute. Much focus has been on what is the appropriate discount rate to convert future lost earnings into a lump sum amount. Conflicting or ambiguous legal guidance by the courts has lead to wide disparities in discount rate methodology. This paper presents a fresh, alternative approach to valuing lost earnings in damage awards using current market data from the zero coupon Treasury bond curve. Unlike many other approaches this approach satisfies legal requirements while offering several theoretical and practical benefits: (a) default free discounting; (b) market-based prices and yields; (c) a fully objective way to recompute awards if market conditions change materially in the course of litigation; (d) satisfaction of the “parity in risk” principal which requires consistent treatment of uncertainty in cash flows and discount rate, which is violated by using an arbitrary average of three-month T-bill rates if inflation is embedded in lost earnings; and (e) a theoretically investible stream of cash flows that can be maturity matched against projected lost earnings.