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Discounting the distant future: how much do uncertain rates increase valuations

By Richard Newell and William Pizer

Abstract

portion of this paper may be reproduced without permission of the authors. Discussion papers are research materials circulated by their authors for purposes of information and discussion. They have not necessarily undergone formal peer review or editorial treatment. Discounting the Distant Future: How Much Do Uncertain Rates Increase Valuations? Costs and benefits in the distant future—such as those associated with global warming, long-lived infrastructure, hazardous and radioactive waste, and biodiversity—often have little value today when measured with conventional discount rates. We demonstrate that when the future path of this conventional rate is uncertain and persistent (i.e., highly correlated over time), the distant future should be discounted at lower rates than suggested by the current rate. We then use two centuries of data on U.S. interest rates to quantify this effect. Using both random walk and mean-reverting models, we compute the certaintyequivalent rate—that is, the single discount rate that summarizes the effect of uncertainty and measures the appropriate forward rate of discount in the future. Using the random walk model, which we consider more compelling, we find that the certainty-equivalent rate fall

Topics: JEL Classification Numbers
Year: 2003
OAI identifier: oai:CiteSeerX.psu:10.1.1.418.2722
Provided by: CiteSeerX
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