Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2011/4: The long term equilibrium interest rate and risk premiums under uncertainty

Knut K. Aase ()
Additional contact information
Knut K. Aase: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

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-codes: D00; G00

34 pages, February 28, 2011

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