Discounting the discount rate

Federal funds rate ; Discount window

Foreign currency returns and systematic risks

The decomposition of the market return into its cash-flow and discount-rate news driven components reveals that excess returns on low forward discount currency portfolios load positively on "good" news about the stock market's discount rates while high forward discount currencies load negatively on this news. Average currency portfolio returns are hence explained by different sensitivities to discount-rate news. A two-beta version of the CAPM, distinguishing between cash-flow and discount-rate betas, is able to price both currency and stock portfolio returns at the same time. Finally, we find that the relation between stock market news and foreign currency returns varies across the two either discount-rate news or both discount-rate and cash-flow news driven stock market booms of the past two decades.Currency returns, cash-flow news, discount-rate news, market return, UIP

Decomposing the social discount rate

Recent modelling of the costs and benefits of climate change has renewed debate surrounding assumptions regarding the social discount rate in analysing the impacts of environmental change. Previous literature segments the social discount rate into being influenced by two key factors; the rate of pure time preference and the elasticity of marginal utility of future consumption. These components of the social discount rate reinforce the linkages between the choice of social discount rate and intergenerational distribution. In an extension of previous work by the author on intergenerational distributional preferences, this paper discusses the relationship between intergenerational equity and the social discount rate. The work has significant policy implications given the sensitivity of Cost Benefit Analysis outcomes to assumptions regarding the social discount rate.Intergenerational equity, Social discount rate, Environmental Economics and Policy,

The market's reaction to discount changes: what's behind the announcement effect?

Market interest rates respond to discount rate changes. What is the reason for this response. This paper investigates several competing hypotheses of why markets respond to discount rate changes. Evidence that the response is invariant to changes in the Federal Reserve's operating procedure suggests that it is purely an "announcement effect." Contrary to common belief the evidence suggests that the does not depend critically on whether the discount rate change is unanticipated, because all discount rate changes appear to be largely unanticipated. Additional evidence suggests that, despite the fact that there have been instances when discount rate was used to signal a change in policy, e.g., the one percentage point increase in the discount rate in October 1979, generally speaking, discount rate changes do not appear to have "signaled" a change in monetary policy. This suggests that the common assertion that market interpret discount rate changes as a signal of a change in Fed policy is incorrect. It appears that changes expectations about monetary policy is not the only reason--and perhaps not the most important reason--for the market's reaction to changes in the discount rate.Monetary policy - United States ; Discount

Discounting and Divergence of Opinion

The objective of this paper is to adopt a general equilibrium model and determine the socially efficient discount factor, risk free rate and discount rate when there are heterogeneous anticipations about the growth of the economy as well as heterogeneous time preference rates. Among others we tackle the following questions. Is the socially efficient discount factor an arithmetic average of the individual subjectively anticipated discount factors? More generally, can the Arrow-Debreu prices, the risk free rates, the subjectively expected socially efficient discount factors and discount rates be obtained as an average of the individual subjectively anticipated ones? Can beliefs dispersion be analyzed as a sort of additional risk or uncertainty leading to possibly lower discount rates? Is it socially efficient, when diversity of opinion is taken into account, to reduce the discount rate per year for more distant horizons? If so, what is the trajectory of the decline?discount rate, risk free rate

Discounting, Inequalities and Economic Convergence

The aim of this paper is to examine the impact of inequalities and economic convergence on the efficient discount rate, in the absence of any risk-sharing scheme. We consider an economy in which the initial consumption level and the distribution of consumption growth are heterogeneous. The benchmark case is when inequalities are permanent and relative risk aversion is constant. The discount rate is not affected by inequalities in that case. We first relax the assumption on risk aversion, and we derive conditions under which permanent inequalities reduce the discount rate. If relative prudence is larger than unity, an increase in economic convergence always raises the efficient discount rate. In a realistic calibration exercise, we show that the effect of economic convergence is to triple the discount rate, from less 2% to more than 6%.prudence, temperance, concordance, discount rate

Estimating Discount Functions with Consumption Choices over the Lifecycle

Intertemporal preferences are difficult to measure. We estimate time preferences using a structural buffer stock consumption model and the Method of Simulated Moments. The model includes stochastic labor income, liquidity constraints, child and adult dependents, liquid and illiquid assets, revolving credit, retirement, and discount functions that allow short-run and long-run discount rates to differ. Data on retirement wealth accumulation, credit card borrowing, and consumption-income comovement identify the model. Our benchmark estimates imply a 40% short-term annualized discount rate and a 4.3% long-term annualized discount rate. Almost all specifications reject the restriction to a constant discount rate. Our quantitative results are sensitive to assumptions about the return on illiquid assets and the coefficient of relative risk aversion. When we jointly estimate the coefficient of relative risk aversion and the discount function, the short-term discount rate is 15% and the long-term discount rate is 3.8%.

Asset Returns, Discount Rate Changes and Market Efficiency

The primary purpose of this paper is to reconcile the previous findings of discount rate endogeneity with the presence of discount rate announcement effects in securities markets. The crux of this reconciliation is the dictinction between "technicral" discount rate changes that are endogenous and "non-technical" changes which contain some informative policy implications. In essence, we attempt to separate expected discount rate changes from unexpected changes, or equivalently, the expected component of discount rate changes from the unexpected component. If markets are efficient, the former should have no announcement effects while the latter may be associated with an announcement effect. Accordingly, the focus of the empirical analysis is on the interaction between discount rate exogeneity, the specific monetary policy regime, and announcement effects. In addition, we examine whether the behaviorof these markets in the post-announcement period is consistent with the rapid price adjustment implied by market efficiency.

Discounting and Relative Consumption

This paper analyzes optimal social discount rates where people derive utility from relative consumption. We identify and compare three separate discount rates -- the social rate (taking positional externalities into account), the private rate, and the conventional Ramsey rate. Two main findings resulted for the standard case with a positive growth rate -- 1) the social discount rate exceeds the private discount rate if the degree of positionality increases with consumption, and 2) the social discount rate is smaller than the Ramsey rate if preferences are quasi-concave in own and reference consumption, and exhibit risk aversion with respect to reference consumption. Numerical calculations demonstrate that the latter difference may be substantial and economically important for such issues as global warming.discounting, relative consumption, Ramsey rule, degree of positionality, keeping up with the Joneses

On the Relative Accuracy of Discounting Based on Risk-Free and Risky Portfolios

The degree of risk that should be incorporated into the net discount rate that is used to estimate the present value of future lost earnings has been the subject of controversy. While some forensic economists insist that a risk-free discount rate must be used, others have offered economic arguments that support use of a risk-adjusted rate. Historical simulation studies have found that, when the discount rate is based on risk-free or low-risk securities, the historical averages method of estimating present value is subject to large forecast errors due to significant changes in net discount rates over time. This study explores whether basing the discount rate on mixed portfolios of equities, intermediate- term government bonds, and Treasury bills might result in more accurate estimation. Using the historical averages method with data covering the period 1926-2008, results are generated for four mixed portfolios of varying degrees of risk, and these results are compared to the results obtained with Treasury bills, intermediate-term government bonds and long-term corporate bonds. The historical simulations do show that the mixed portfolios often provide more accurate estimates. These results should be of considerable interest to forensic economists who believe that some degree of risk should be incorporated into the discount rate