CALGARY, April 8, 2015 /CNW/ - Discount rates are essential to applied finance, especially in setting prices for regulated utilities, valuing the liabilities of insurance companies and defined benefit pension plans. Many terms in finance can be confusing when they are used to mean the same thing. This is particularly true for the term "discount rate". Conceptually, the discount rate is an individual's marginal rate of substitution between current and future wealth - the slope of the individual's indifference curve when faced with investment decisions. As such, it is the minimum rate of return required by an individual to make an investment, so it is also called the required rate of return.
A report released today by The School of Public Policy and author Laurence Booth, reveals the building blocks for how discount rates are estimated, why they are vital and provides strong recommendations for adjustments. In the U.S., the average equity market required return was estimated at 8.0 per cent; Canada's is 7.40 per cent, due to the lower market risk premium and the lower risk-free rate. According to the report "the ideal base long-term interest rate used in risk premium models should be 4.0 per cent, producing an overall expected market return of 9-10.0 per cent. The same data indicate that allowed returns to utilities are currently too high, while the use of current bond yields in solvency valuations of pension plans and life insurers is unhelpful unless there is a realistic expectation that the plans will soon be terminated."
It is critical that the discount rate is specified correctly in order to set public utility rates, pension contributions and life insurance rates. Yet, since the onset of the financial crisis, considerable controversy has emerged as to whether the old rules/procedures have remained constant or changed, that is, whether or not we now have a "new normal."
The paper can be downloaded at http://www.policyschool.ucalgary.ca/?q=research
SOURCE The School of Public Policy - University of Calgary
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