Abstract
Because of risk aversion, any sensible investment valuation system should value less projects that contribute more to the aggregate risk. In theory, this is done by adjusting discount rates to consumption betas. But in reality, most public institutions use a dis-count rate that is rather insensitive to the risk profile of their investment projects. The economic consequences of the implied misallocation of capital are severe. I calibrate a Lucas model in which the investment opportunity set contains a constellation of projects with different expected returns and risk profiles. The model matches the traditional finan-cial and macro moments, together with the observed heterogeneity of assets’ risk profiles. The welfare loss of using a single discount rate is equivalent to a permanent reduction in consumption that lies somewhere between 15% and 45% depending upon which single discount rate is used.
Keywords
Discounting; investment theory; asset pricing; carbon pricing; Arrow-Lind theorem; WACC fallacy; rare disasters; capital budgeting;
JEL codes
- G12: Asset Pricing • Trading Volume • Bond Interest Rates
- H43: Project Evaluation • Social Discount Rate
- Q54: Climate • Natural Disasters • Global Warming
Replaces
Christian Gollier, The welfare cost of ignoring the beta, January 2021, revised April 2022.
Reference
Christian Gollier, “The welfare cost of ignoring the beta”, TSE Working Paper, n. 24-1556, July 2024.
See also
Published in
TSE Working Paper, n. 24-1556, July 2024