Why Expected Discount Factors Yield Incorrect Expected Present Values
Why Expected Discount Factors Yield Incorrect Expected Present Values

Summary/Abstract: Compound and discount factors determine the relationship between present and future values. When interest rates are stochastic, expected compound factors are computed by probability weighting all possible compound factors. It is customary to proceed likewise to compute expected discount factors. It has been noted that risk neutral certainty equivalent interest rates differ when computed from expected compound or expected discount factors, yielding alternative project rankings. This paper shows that expected discount factors yield incorrect expected present values because, unlike in the deterministic case, they are not the reciprocals of the corresponding expected compound factors.

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