A Theory of the Decreasing Term Structure of Discount Rates
A Theory of the Decreasing Term Structure of Discount Rates
This chapter aims to provide a unified theoretical foundation to the term structure of discount rates. To do this the chapter develops a benchmark model based on two assumptions: individual preferences toward risk, and the nature of the uncertainty over economic growth. Previously, it was shown that constant relative risk aversion, combined with a random walk for the growth of log consumption, yields a flat term structure for efficient discount rates. In this chapter, these two assumptions are relaxed by using a stochastic dominance approach. Stochastic models of economic growth with mean-reversion, Markov switches, and parametric uncertainty all exhibit some forms of positive statistical dependence of successive growth rates. Because this tends to magnify the long-term risk, it is the driving force of the decreasing nature of the term structure.
Keywords: concordance, term structure, risk preferences, uncertainty, risk aversion, random walk, stochastic dominance approach, economic growth rates, long-term risk
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