The paper deals with the disputed question in Finance of the inclusion in the discounting interest rate of a risk premium for discounting risky sums. It appears to be a nice and simplifying assumption playing a key role in handling many models. On the other side the theoretical foundations of the procedure are questionable. In any case the receipt is simple: to discount a random amount X one should simply discount its expected value m=E(X) with an interest rate greater than the risk-free one. The majorization should be increasing with the risk, operationally with the variance of X. Our aim is to use the Expected Utility approach in the version incorporating time. We shall see that within this framework one obtains, at least in the first approximation, a decision rule displaying some analogy with the common one.
Discounting risky sums
BECCACECE, FRANCESCA;CIGOLA, MARGHERITA;PECCATI, LORENZO
1995
Abstract
The paper deals with the disputed question in Finance of the inclusion in the discounting interest rate of a risk premium for discounting risky sums. It appears to be a nice and simplifying assumption playing a key role in handling many models. On the other side the theoretical foundations of the procedure are questionable. In any case the receipt is simple: to discount a random amount X one should simply discount its expected value m=E(X) with an interest rate greater than the risk-free one. The majorization should be increasing with the risk, operationally with the variance of X. Our aim is to use the Expected Utility approach in the version incorporating time. We shall see that within this framework one obtains, at least in the first approximation, a decision rule displaying some analogy with the common one.
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