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1 The long term discount rate: Some comments from a practical point of view 24. mai 2012 Prof. Thore Johnsen Norwegian School of Economics (NHH)

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Presentation on theme: "1 The long term discount rate: Some comments from a practical point of view 24. mai 2012 Prof. Thore Johnsen Norwegian School of Economics (NHH)"— Presentation transcript:

1 1 The long term discount rate: Some comments from a practical point of view 24. mai 2012 Prof. Thore Johnsen Norwegian School of Economics (NHH)

2 2 Structure  Are economic (growth) models useful in setting public discount rates?  A simple market calibration exercise  Risk premium information from the stock market  Summing up

3 3 Are economic (growth) models useful in setting public discount rates?  Of course, but with a minimum of market calibration  But, the models have not been very useful in explaining (or predicting) the financial markets Discount rate = Risk free rate (real) + Risk Premium  Risk Free rate puzzle: too high  Equity premium puzzle: too low  Too much degree of freedom in more elaborate models,  or too complex and unstable for practical use

4 4 Structure  Are economic (growth) models useful in setting public discount rates?  A simple market calibration exercise  Few long instruments with «risk free» real return matching except for the UK 50-year indexed Gilt- market (excess demand)  Will instead use the US 100-year corporate bond market

5 5 100 Year Bonds - Yields Walt Disney 2093 vs 2032 Coca Cola 2098 vs 2036 US Treasury 2030

6 6 100 Year Bonds – Yield spreads WD 2032 vs Treasury CC 2036 vs Treasury

7 7 100 Year Bonds – Forward Yields  (TL  RL - TS  RS) / (TL-TS) WD93 = WD32 + Fwd purch. WD93 in 2032 CC98 = CC36 + Fwd purch. CC96 in 2036

8 8 Uncertain future price and yield (in ) - Convexity adjusted forward yield Dybvig, et. Al. (JB 1996; Weitzman JEEM 1998)  Price long bond = Price short bond + E[Future Price]  Determine forward yield from expected future price

9 9 100 Year Bonds – Stable 3.2 % Forward Yields R93  [T32  R32 + (T93-T32)  3.2%]/T93 R98  [T36  R36 + (T98-T36)  3.2%]/T98

10 10 Structure  Are economic (growth) models useful in setting public discount rates?  A simple market calibration exercise  Risk premium information from the stock market

11 sep. 2008: Down 8.5 %  SELL !! 1. oktober 2008: Up 5.5 %  BUY !! Two days in the life of Oslo Stock Exhange…..

12 12 The stock market is driven by expectations and risk u Stocks give a w return when investors demand more (and a higher return when they expect less)  Stock market and economic growth uncorrelated, across markets and over time (Dimson, Marsh & Staunton)  (but the stock market is a good predictor for future growth) u High correlation between long-run stock and bond returns, while short-run returns are negatively correlated Discount rate = Risk free rate (real) + Risk Premium

13 13 Pricing of OSE Large Caps Nov vs Aug 2008 Aug 08: RF 5.0 % MP 4.5 %  Cost 12 % Nov 08: RF 3.8 % MP 7 %  Cost 14.5%

14 14 Cyclical risk premiums US

15 Equity, gov. bonds and GNP-growth Norway / US (deflated, log) NORWAY: 0.60  Equity  Bonds = 3.2 %  GNP-growth US: 0.60  Equity  Bonds = 4.5 % >> GNP-growth 8 % 6,5 % ,5 % 7 % > GNP: 2.7 % -Real rate:1.8% -GNP: 2.4 % -Real rate:3.8% 2.6 % 2.5 %

16 16 15-yrs geometric real returns Norway / US 1900 – : Equity: 3,2% Gov Bonds: 1,1% Real interest: 1,2% : Equity: 5,2% Gov. bonds: 2,9% Real interest: 2,5% : Equity: 6,9% Gov. bonds: 1,1% Real interest: 0,7% : Equity: 5,4% Gov. bonds: 3,3% Real inteest: 1,1% NORWAY US

17 17 Summing up  Yes, the risk free (real) rate term structure has a dip at the (very) long end  But, the the term structure of risk premiums are problably upward bending (e.g. Pastor & Stambaug, JF 2012)  Use market calibration (political defense)  More focus on benefits/cash flows than discount rates in public projects


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