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Discounting Mean Reverting Cash Flows with the Capital Asset Pricing Model
Author(s) -
Giaccotto Carmelo
Publication year - 2007
Publication title -
financial review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.621
H-Index - 47
eISSN - 1540-6288
pISSN - 0732-8516
DOI - 10.1111/j.1540-6288.2007.00170.x
Subject(s) - economics , discounting , capital asset pricing model , mean reversion , econometrics , cash flow , skewness , sharpe ratio , consumption based capital asset pricing model , terminal value , asset (computer security) , financial economics , operating cash flow , finance , portfolio , computer science , computer security
Discounting cash flows requires an equilibrium model to determine the cost of capital. The CAPM of Sharpe and the intertemporal asset pricing model of Merton (1973) offer a theoretical justification for discounting at a constant risk adjusted rate. Two problems arise with this application. First, for mean reverting cash flows the risk adjustment is unknown, and second, if the present value is compounded forward then the distribution of future wealth is likely right skewed. I develop equilibrium discount rates for cash flows whose level or growth rate is mean reverting. Serial correlation also largely eliminates the skewness problem.