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Discounting Mean Reverting Cash Flows with the Capital Asset Pricing Model

Authors

  • Carmelo Giaccotto

    Corresponding author
    1. University of Connecticut
      * Corresponding author: Department of Finance, School of Business, University of Connecticut, 2100 Hillside Road, Unit 1041, Storrs, CT 06269-1041; E-mail: CGiaccotto@business.uconn.edu
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  • I have received many helpful comments from John Clapp, Erasmo Giambona, Joe Golec, John Harding, Shantaram Hegde, Hossein Kazemi, Tom O'Brien, Rex Santerre, Jimmy Sfiridis, You Taewoo, John Vernon, and seminar participants at the University of Connecticut, the University of Massachusetts, and the 2006 Eastern Finance Association in Philadelphia. I thank also an anonymous referee and Arnie Cowan (the editor) for their valuable comments. All remaining errors are the sole responsibility of the author.

* Corresponding author: Department of Finance, School of Business, University of Connecticut, 2100 Hillside Road, Unit 1041, Storrs, CT 06269-1041; E-mail: CGiaccotto@business.uconn.edu

Abstract

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.

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