1. What is the “discount rate” and what is the “present value” of future returns
ID: 2764630 • Letter: 1
Question
1. What is the “discount rate” and what is the “present value” of future returns? Define in words and mathematically.
2. Why do people discount the value of future returns? What determines the discount rate that individuals will use? Is your rate the same as the rate you would expect for your parents? Is it the same as you would expect for your grandparents?
3. What do individuals do if the market discount rate is higher or lower than their own rate? How might their behavior change the market rate?
4. What is a “risk premium”? How do different people assess the risk of different investments?
Explanation / Answer
1. The discount rate is the rate that is applied to bring the future value to the present value. It is often the rate of interest which is paid to cover inflation in the economy.
The present value (PV) is defined as PV = FV/(1+r)^ n where
FV = Future value, r = discount rate, n = number of years
2. It is because of the inflation or rise in prices that is prevalent in the economy of any country. So if the inflation is higher, the interest rates will be high and so will be the discount rate. So the inflation determines the discount rates. No as the inflation has reduced, the rate that we use will be lower than that our parents used and will be very low when compared to the rates our grandparents used.
3. If the discount rate is higher than the market rate, this means that their money will depreciate faster than the market (which is bad). If the discount rates are lower than market rate, it means that their money will depreciate at a rate lower than the market (which is good)
Hence if the discount rate is higher, they need to take steps to lower their discount rate.
4. Risk premium refers to the amount of risk an individual can take. For example, if you are a risk averse investor who invests only in debt, you risk premium is very low. On the other hand, if you are a person who invests is small cap stocks, your risk premium is vet high.
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