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Why expected discount factors yield incorrect expected present values

Author

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  • Szekeres, Szabolcs

Abstract

Compound and discount factors determine the relationship between present and future values. When interest rates are stochastic, expected compound factors are computed by probability weighting all possible compound factors. It is customary to proceed likewise to compute expected discount factors. It has been noted that risk neutral certainty equivalent interest rates differ when computed from expected compound or expected discount factors, yielding alternative project rankings. This paper shows that expected discount factors yield incorrect expected present values because, unlike in the deterministic case, they are not the reciprocals of the corresponding expected compound factors.

Suggested Citation

  • Szekeres, Szabolcs, 2018. "Why expected discount factors yield incorrect expected present values," MPRA Paper 91187, University Library of Munich, Germany, revised 02 Jan 2019.
    • Handle: RePEc:pra:mprapa:91187
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    File URL: https://mpra.ub.uni-muenchen.de/91187/1/MPRA_paper_91187.pdf
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    References listed on IDEAS

    as
    1. Gollier, Christian, 2004. "Maximizing the expected net future value as an alternative strategy to gamma discounting," Finance Research Letters, Elsevier, vol. 1(2), pages 85-89, June.
    2. Ben Groom & Cameron Hepburn & Phoebe Koundouri & David Pearce, 2005. "Declining Discount Rates: The Long and the Short of it," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 32(4), pages 445-493, December.
    3. Pazner, Elisha A & Razin, Assaf, 1975. "On Expected Value vs. Expected Future Value," Journal of Finance, American Finance Association, vol. 30(3), pages 875-877, June.
    4. 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.
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    Cited by:

    1. Szekeres, Szabolcs, 2020. "Checking the Evidence for Declining Discount Rates," MPRA Paper 102233, University Library of Munich, Germany.
    2. Szekeres, Szabolcs, 2020. "The real solution of the Weitzman-Gollier Puzzle," MPRA Paper 102344, University Library of Munich, Germany.
    3. Szekeres, Szabolcs, 2020. "Correcting the Error in Gamma Discounting," MPRA Paper 102232, University Library of Munich, Germany, revised 27 Jul 2020.

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    More about this item

    Keywords

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    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate

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