TY - JOUR
AU - Weitzman,Martin L.
TI - Rare Disasters, Tail-Hedged Investments, and Risk-Adjusted Discount Rates
JF - National Bureau of Economic Research Working Paper Series
VL - No. 18496
PY - 2012
Y2 - October 2012
UR - http://www.nber.org/papers/w18496
L1 - http://www.nber.org/papers/w18496.pdf
N1 - Author contact info:
Martin Weitzman
Department of Economics
Harvard University
Littauer 313
Cambridge, MA 02138
Tel: 617/495-5133
Fax: 617/495-8570
E-Mail: mweitzman@harvard.edu
AB - What is the best way to incorporate a risk premium into the discount rate schedule for a real investment project with uncertain payoffs? The standard CAPM formula suggests a beta-weighted average of the return on a safe investment and the mean return on an economy-wide representative risky investment. Suppose, though, that the project constitutes a tail-hedged investment, meaning that it is expected to yield positive payoffs in catastrophic states of nature. Then the model of this paper suggests that what should be combined in a weighted average are not the two discount rates, but rather the corresponding two discount factors. This implies an effective discount rate schedule that declines over time from the standard CAPM formula down to the riskfree rate alone. Some simple numerical examples are given. Implications are noted for discounting long-term public investments and calculating the social cost of carbon in climate change.
ER -