Getting to the Bottom of Discount Rate Variation

Investors have long held that expected excess returns – or risk premia – vary significantly over time. But there is yet a consensus for why that remains the case or whether increases in risk premia spell good or bad news for investors.

But new research from Maryland Smith’s Serhiy Kozak sheds some light.

Unfortunately for investors, the news is bad, Kozak finds, concluding that the average price is negative. That means when the marginal utility of wealth is high, so are discount rates, says Kozak, assistant professor of finance at the University of Maryland’s Robert H. Smith School of Business. The finding is important for understanding which economic forces might move expected stock returns in the first place, he says.

The paper, which was produced with a coauthor from the University of Colorado and published in the Journal of Financial Economics, proposes a new non-parametric indicator for conveying a negative average price of discount rate risk.

Previous research efforts have primarily relied on predictive regressions to estimate the price of discount-rate risk.

What should be apparent to investors, Kozak says, is that sudden increases in aggregate expected excess returns are perceived as bad news by rational traders, who require higher expected returns for holding exposure to this news. This evidence is consistent with theoretic models featuring stochastic technology or preferences as the drivers of time-varying expected returns, but it is inconsistent with canonical models of sentiment.

Read the full research, “Why Do Discount Rates Vary?,” in the Journal of Financial Economics.