Discounting the distant future: How much do uncertain rates increase valuations?

Published

Journal Article

We demonstrate that when the future path of the discount rate is uncertain and highly correlated, the distant future should be discounted at significantly lower rates than suggested by the current rate. We then use two centuries of US interest rate data to quantify this effect. Using both random walk and mean-reverting models, we compute the "certainty-equivalent rate" that summarizes the effect of uncertainty and measures the appropriate forward rate of discount in the future. Under the random walk model we find that the certainty-equivalent rate falls continuously from 4% to 2% after 100 years, 1% after 200 years, and 0.5% after 300 years. At horizons of 400 years, the discounted value increases by a factor of over 40,000 relative to conventional discounting. Applied to climate change mitigation, we find that incorporating discount rate uncertainty almost doubles the expected present value of mitigation benefits. © 2003 Elsevier Science (USA). All rights reserved.

Full Text

Duke Authors

Cited Authors

  • Newell, RG; Pizer, WA

Published Date

  • January 1, 2003

Published In

Volume / Issue

  • 46 / 1

Start / End Page

  • 52 - 71

International Standard Serial Number (ISSN)

  • 0095-0696

Digital Object Identifier (DOI)

  • 10.1016/S0095-0696(02)00031-1

Citation Source

  • Scopus