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The long term discount rate: Some comments from a practical point of view 24. mai 2012

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The long term discount rate: Some comments from a practical point of view 24. mai 2012. Prof. Thore Johnsen Norwegian School of Economics (NHH). Structure. Are economic (growth) models useful in setting public discount rates? A simple market calibration exercise

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The long term discount rate: Some comments from a practical point of view 24. mai 2012
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  1. The long term discount rate: Some comments from a practical point of view24. mai 2012 Prof. Thore Johnsen Norwegian School ofEconomics (NHH)

  2. Structure • Are economic (growth) modelsuseful in setting public discount rates? • A simple market calibrationexercise • Risk premiuminformation from the stock market • Summing up

  3. Are economic (growth) modelsuseful in setting public discount rates? • Ofcourse, butwith a minimum of market calibration • But, themodels have not beenveryuseful in explaining (or predicting) thefinancial markets Discount rate = Risk free rate (real) + Risk Premium • Risk Free rate puzzle: toohigh • Equity premiumpuzzle: toolow • Too muchdegreeoffreedom in more elaboratemodels, • or toocomplex and unstable for practicaluse

  4. Structure • Are economic (growth) modelsuseful in setting public discount rates? • A simple market calibrationexercise • Few long instruments with «risk free» real return matching except for the UK 50-year indexedGilt-market (excessdemand) • Will insteadusethe US 100-year corporatebond market

  5. 100 Year Bonds - Yields 2001 - 2012 Walt Disney 2093vs 2032 US Treasury 2030 Coca Cola 2098vs 2036 US Treasury 2030

  6. 100 Year Bonds – Yield spreads 2001 - 2012 2093- 2032 WD 2032vsTreasury 2030 2098- 2036 CC 2036vsTreasury 2030

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

  8. Uncertain future price and yield (in 2032-36) - Convexity adjusted forward yield • Price long bond = Price shortbond + E[Future Price] • Determine forward yield from expectedfuture price Dybvig, et. Al. (JB 1996; Weitzman JEEM 1998)

  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. Structure • Are economic (growth) modelsuseful in setting public discount rates? • A simple market calibrationexercise • Risk premiuminformation from the stock market

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

  12. The stock market is driven by expectations and risk • 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) • 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. 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% 13

  14. Cyclical risk premiums US

  15. NORWAY: 0.60Equity + 0.40Bonds = 3.2 %  GNP-growth US: 0.60Equity + 0.40Bonds = 4.5 % >> GNP-growth Equity, gov. bonds and GNP-growth Norway / US (deflated, log) 1900 - 2010 > 1980 8 % 2.6 % 6,5 % 7 % -GNP: 2.4 % -Real rate:3.8% 6,5 % 2.5 % -GNP: 2.7 % -Real rate:1.8%

  16. 1900-1959: Equity: 3,2% Gov Bonds: 1,1% Real interest: 1,2% 1960-2011: Equity: 5,2% Gov. bonds: 2,9% Real interest: 2,5% 1900-1959: Equity: 6,9% Gov. bonds: 1,1% Real interest: 0,7% 1960-2011: Equity: 5,4% Gov. bonds: 3,3% Real inteest: 1,1% 15-yrs geometric real returns Norway / US 1900 – 2011 NORWAY US

  17. Summing up • Yes, the risk free (real) rate term structure has a dip at the (very) long end • But, thethe term structureof risk premiumsareproblablyupward bending (e.g. Pastor & Stambaug, JF 2012) • Use market calibration (politicaldefense) • More focus on benefits/cash flowsthandiscount rates in public projects