Discussion Issues and Derivations
- How can investors with different degrees of risk aversion agree on a discount rate?
Intuitively, investors who are more risk averse should end up with higher discount rates than investors who are less risk averse. This would imply that present value would be an entirely subjective estimate, varying with the risk aversion of the investor coming up with the discount rate. What allows investors to arrive at a common discount rate, even when they have different degrees of risk aversion, is the fact that there exist capital markets where investors can lend and borrow at a market interest rate. This capacity to lend and borrow will allow more risk averse investors to lend money at an interest rate to investors who are less risk averse, who will then invest in risky projects. This is called the separation theorem.