The Long Term Equilibrium Interest Rate and Risk Premiums Under Uncertainty

35 Pages Posted: 6 Mar 2011 Last revised: 8 Apr 2011

See all articles by Knut K. Aase

Knut K. Aase

Norwegian School of Economics (NHH) - Department of Business and Management Science

Date Written: February 28, 2011

Abstract

Both the equilibrium interest rate and the equity premium, as well as risk premiums of risky investments are all important quantities in cost-benefit analyses. In the light of the current (2008) financial crisis, it is of interest to study models that connect the the financial sector with the real economy. The effects of climate change has, on the other hand, been the subject of extensive discussions, for example in connection with the Stern report. The paper addresses both these issues, first based on standard assumptions. In particular we investigate what is needed to have long-term interests lower than short term rates. Our model allows us to tell what happens to risk premiums in turbulent times, consistent with observations. Next we extend the pure exchange model to a production economy. As a result we obtain an equilibrium term structure of interest rates, as well as a model for the equity premium. We end by a discussion of risk adjustments of the discount factor. For projects aimed at insuring future consumption, the interest rate is smaller than the risk free rate. Mitigation can have the characteristics of such a project.

Keywords: Dynamic equilibrium, the Lucas model, term structure, CIR, pure exchange, production economy, equity premium puzzle, risk free rate puzzle, climate models, Stern Review

JEL Classification: D00, G00

Suggested Citation

Aase, Knut K., The Long Term Equilibrium Interest Rate and Risk Premiums Under Uncertainty (February 28, 2011). NHH Dept. of Finance & Management Science Discussion Paper No. 2011/4. Available at SSRN: https://ssrn.com/abstract=1774704 or http://dx.doi.org/10.2139/ssrn.1774704

Knut K. Aase (Contact Author)

Norwegian School of Economics (NHH) - Department of Business and Management Science ( email )

Helleveien 30
Bergen, NO-5045
Norway

Register to save articles to
your library

Register

Paper statistics

Downloads
60
Abstract Views
717
rank
364,640
PlumX Metrics