IDEAS home Printed from https://ideas.repec.org/p/ide/wpaper/26592.html
   My bibliography  Save this paper

Evaluation of long-dated investments under uncertain growth trend, volatility and catastrophes

Author

Listed:
  • Gollier, Christian

Abstract

Because of the uncertainty about how to model the growth process of our economy, there is still much confusion about which discount rates should be used to evaluate actions having long-lasting impacts, as in the contexts of climate change, social security reforms or large public infrastructures for example. We characterize efficient discount rates when the growth of log consumption follows a random walk with uncertain parameters. We examine different models in which the parametric uncertainty affects the trend and the volatility of growth, or the frequency of catastrophes. This uncertainty implies that the term structures of the risk free discount rate and of the aggregate risk premium are respectively decreasing and increasing. It also implies that the discount rate is increasing with maturity if the beta of the investment is larger than half of relative risk aversion. Another important consequence of parametric uncertainty is that the risk premium is not proportional to the beta of the investment. Finally, we apply our findings to the evaluation of climate change policy. We argue in particular that the beta of actions to mitigate climate change is relatively large, so that the term structure of the associated discount rates should be increasing.

Suggested Citation

  • Gollier, Christian, 2012. "Evaluation of long-dated investments under uncertain growth trend, volatility and catastrophes," IDEI Working Papers 754, Institut d'Économie Industrielle (IDEI), Toulouse, revised Sep 2015.
  • Handle: RePEc:ide:wpaper:26592
    as

    Download full text from publisher

    File URL: http://www.tse-fr.eu/sites/default/files/TSE/documents/doc/by/gollier/risk_premium.pdf
    File Function: Full text
    Download Restriction: no

    Other versions of this item:

    References listed on IDEAS

    as
    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. David Backus & Mikhail Chernov & Ian Martin, 2011. "Disasters Implied by Equity Index Options," Journal of Finance, American Finance Association, vol. 66(6), pages 1969-2012, December.
    3. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
    4. Mariano M. Croce & Martin Lettau & Sydney C. Ludvigson, 2015. "Investor Information, Long-Run Risk, and the Term Structure of Equity," Review of Financial Studies, Society for Financial Studies, vol. 28(3), pages 706-742.
    5. Maria Sandsmark & Haakon Vennemo, 2007. "A portfolio approach to climate investments: CAPM and endogenous risk," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 37(4), pages 681-695, August.
    6. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, August.
    7. Weitzman, Martin L., 2010. "Risk-adjusted gamma discounting," Journal of Environmental Economics and Management, Elsevier, vol. 60(1), pages 1-13, July.
    8. Christian Gollier, 2008. "Discounting with fat-tailed economic growth," Journal of Risk and Uncertainty, Springer, vol. 37(2), pages 171-186, December.
    9. Christian Gollier, 2012. "Pricing the Planet's Future: The Economics of Discounting in an Uncertain World," Economics Books, Princeton University Press, edition 1, number 9894.
    10. William R. Cline, 1992. "Economics of Global Warming, The," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 39.
    11. Gollier, Christian, 2002. "Time Horizon and the Discount Rate," Journal of Economic Theory, Elsevier, vol. 107(2), pages 463-473, December.
    12. Robert J. Barro, 2009. "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, American Economic Association, vol. 99(1), pages 243-264, March.
    13. Martin L. Weitzman, 2012. "Rare Disasters, Tail-Hedged Investments, and Risk-Adjusted Discount Rates," NBER Working Papers 18496, National Bureau of Economic Research, Inc.
    14. Martin L. Weitzman, 2009. "On Modeling and Interpreting the Economics of Catastrophic Climate Change," The Review of Economics and Statistics, MIT Press, vol. 91(1), pages 1-19, February.
    15. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
    16. Robert J. Barro, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," The Quarterly Journal of Economics, Oxford University Press, vol. 121(3), pages 823-866.
    17. Dreze, Jacques H. & Modigliani, Franco, 1972. "Consumption decisions under uncertainty," Journal of Economic Theory, Elsevier, vol. 5(3), pages 308-335, December.
    18. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    19. Ian W. Martin, 2013. "Consumption-Based Asset Pricing with Higher Cumulants," Review of Economic Studies, Oxford University Press, vol. 80(2), pages 745-773.
    20. Martin L. Weitzman, 2007. "Subjective Expectations and Asset-Return Puzzles," American Economic Review, American Economic Association, vol. 97(4), pages 1102-1130, September.
    21. Weitzman, Martin L., 1998. "Why the Far-Distant Future Should Be Discounted at Its Lowest Possible Rate," Journal of Environmental Economics and Management, Elsevier, vol. 36(3), pages 201-208, November.
    22. repec:hrv:faseco:33373344 is not listed on IDEAS
    23. Arrow, Kenneth J & Lind, Robert C, 1970. "Uncertainty and the Evaluation of Public Investment Decisions," American Economic Review, American Economic Association, vol. 60(3), pages 364-378, June.
    24. David Laibson, 1997. "Golden Eggs and Hyperbolic Discounting," The Quarterly Journal of Economics, Oxford University Press, vol. 112(2), pages 443-478.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Gollier, Christian, 2012. "Asset pricing with uncertain betas: A long-term perspective," IDEI Working Papers 752, Institut d'Économie Industrielle (IDEI), Toulouse.
    2. Gollier, Christian, 2012. "A theory of rational short-termism with uncertain betas," LERNA Working Papers 12.14.371, LERNA, University of Toulouse.
    3. Freeman, Mark C. & Wagner, Gernot & Zeckhauser, Richard J., 2015. "Climate Sensitivity Uncertainty: When Is Good News Bad?," Working Paper Series rwp15-002, Harvard University, John F. Kennedy School of Government.
    4. Hjort, Ingrid, 2016. "Potential Climate Risks in Financial Markets: A Literature Overview," Memorandum 01/2016, Oslo University, Department of Economics.
    5. Giglio, Stefano & Maggiori, Matteo & Stroebel, Johannes, 2014. "Very long-run discount rates," Globalization and Monetary Policy Institute Working Paper 182, Federal Reserve Bank of Dallas.
    6. Katz, Yuri A., 2017. "Value of the distant future: Model-independent results," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 466(C), pages 269-276.
    7. Freeman, Mark C. & Groom, Ben & Panopoulou, Ekaterini & Pantelidis, Theologos, 2015. "Declining discount rates and the Fisher Effect: Inflated past, discounted future?," Journal of Environmental Economics and Management, Elsevier, vol. 73(C), pages 32-49.
    8. repec:eee:forpol:v:83:y:2017:i:c:p:58-69 is not listed on IDEAS
    9. Corneo, Giacomo, 2015. "Volkswirtschaftliche Bewertung öffentlicher Investitionen," Discussion Papers 2015/12, Free University Berlin, School of Business & Economics.
    10. Rob Aalbers, 2013. "Optimal Discount Rates for Investments in Mitigation and Adaptation," CPB Discussion Paper 257, CPB Netherlands Bureau for Economic Policy Analysis.

    More about this item

    Keywords

    asset prices; term structure; risk premium; decreasing discount rates; parametric uncertainty; CO2 beta; rare events; macroeconomic catastrophes;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ide:wpaper:26592. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: () or (Mikhail Salazkin). General contact details of provider: http://edirc.repec.org/data/idtlsfr.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.