Assessment on "PRICING THE FUTURE, THE AMERICAN CLIMATE PROSPECTUS"

Assessment 4 pages (1234 words) Sources: 0

[EXCERPT] . . . .

I believe that I would make the risk aversion rate higher than average and the growth rate lower. I believe that we should basically caution on the safe side relative to risk aversion given the levels of uncertainty that are inherent in climate models. Furthermore, I think we can develop in ways that are necessarily tied to economic growth and consumption. For example, we could move to more of a services-based economy that consumes less raw materials and finished goods.

Fill in the steps in the derivation of the Ramsey rule that are left out of Dupire's discussion. Start with the simplified utility function u (c0) + exp (-?t) u (ct), and explain what is done to optimize that utility

The impatience parameter is left out in this equation. This basically relates to how people typically prefer to consume things now rather than later. Thus to put off current consumption (cO) we should be compensated with higher levels of future consumption (ct). The ideal rate will balance the utilities that are found in both present and future consumption.

Repeat Dupire's fit of the global warming cost data in the table displayed in the section entitled "A Second Meeting." Use your choices of ?, ?, and g to compute the appropriate discount rate r, and compute the total present value of all of the yearly costs to the year 2100, the last year that we have cost estimates.

Determine the yields to maturity of a few bonds that mature around 2100. How do these yields compare with the discount rate, r, which you estimated in the previous question? How do the resulting present values compare? Can you account for the differences? When you do this comparison, make sure that you assume the same compounding frequency for both the bond yields and r. I can't reasonably expect precise answers here. For one thing, there is the problem of liquidity: many of these bonds don't trade very often, so you are not going to get very good estimates of their market prices, and thus their yields to maturity. But do the best you can. For example, compare the yields of shorter maturity bonds by the same issuer to treasuries of the same maturity. This will give you an idea of spreads due to default risk and liquidity. What about inflation?

The higher the discount rate the lower the present value of a future benefit. The lower the discount rate the higher the present value is of a future benefit. Thus if you care about a sustainable ecological practices for future generations then you would give a lower discount rate in the cost benefit analysis. These considerations also have to account for factors such as inflation which should be included. For example, a two percent discount rate would also be affected by 2% inflation which would work to further reduce the NPV.

Why would you expect that the discount rate is reduced by a correction term when the growth rate is stochastic? In particular, try to explain the meaning of the graph on pg. 67. But, once more, don't go crazy. Look at my slides for the global warming case and try to summarize what I said about stochastic growth rates in a few paragraphs.

I believe that the stochastic growth would make the probability of the effects of catastrophes even more uncertain and thus reduce the discount rate even further. Stochastic growth can be non-linear and unpredictable and can contain a set of random variables. Since we don't really know what the outcomes or effects of various tipping points might be, many of the variables in the… READ MORE

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