1
$\begingroup$

In this paper, Galí and Gambetti calculate the fundamental value of asset price by using policy interest rate as a discount factor. I was wondering if the policy rate can be used in this kind of fashion in a dividend discount pricing model.

$\endgroup$

migrated from stats.stackexchange.com Aug 31 '18 at 17:37

This question came from our site for people interested in statistics, machine learning, data analysis, data mining, and data visualization.

1
$\begingroup$

From a quick look at the paper, I see that the main purpose of the paper is not single-stock valuation. If you are an analyst at an investment bank (for example) and you use as a discount rate for dividends a risk-free rate without attaching a risk premium, then you likely get fired immediately, as that would assume that a stock investment is risk free and deserves a risk free rate for discounting, which is terribly false. So, simplifying a little bit, you shall use a discount rate r which is built as the sum of two components:

  • one is the risk free rate which is usually proxied by the YTM paid annually by same-currency long-term bond like 10y or 20y provided that the selected maturity is liquid enough and there exists a proxy for a risk free in that currency (otherwise you have to draw a return from another currency, like the us 10y and convert it through PP Parity)

  • one is the equity risk premium. In its simplest form the equity risk premium is estimated through CAPM model equation, so ERP= stock_beta *(market_index_return - risk_free), where (market_index_return - risk_free) is the historical average of market excess returns and stock_beta is the market beta of the stock estimated over the same period. Be careful that this is not the only way to estimate the risk premium, whole books are dedicated to it. It is just the simplest one. The risk premium estimate may vary a lot from stock to stock but, just to give you an idea of why it would be wrong to avoid counting it, the equity risk premium can add 10% to the risk-free resulting in a absolutely lower valuation, because this component of the model is what allows you to take into account the specific risk of the business of the company through its beta.

In the paper, it was likely that they only needed a discount rate to discount cash flows. Their intention was not to build a DDM.

$\endgroup$
  • $\begingroup$ I want to add that Galí and Gambetti (2015) have two parts of the paper, the theoretical part where they assume that the investor is risk neutral and the empirical part where they calculate the fundamental component. In the empirical part, they have no clear mention about the used discount rate. in this case, do you suggest that using policy interest rate as a proxy for risk neutrality is sufficient or I need to follow the suggested long term rates? $\endgroup$ – Nord1 Sep 1 '18 at 13:23

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.