Certainty Equivalent, Risk Premium and Asset Pricing

This chapter explores the theory and method for determining discount rate. As well known in finance, discount rate can be estimated by a variety of methods, and the problem seems solved. Unfortunately, this is not the case. Discussions reveal that the only qualified structure for estimating discount rate is “risk free rate + risk premium”. Based on this standard, only the Sharpe CAPM is possible to be right. It turns out that Sharpe CAPM accounts for only systematic risk rather than total risk in determination of the “risk premium”. This cannot be right because the nonsystematic risk cannot be diversified out completely and prudence is the rule of thumb in decision making. To find the solution, we generalize the problem as how to account for total risk in decision making, and further transfer to quantification of the certainty equivalent, and further to the risk equivalent, and finally, we derive the discount rate model or the new CAPM incorporating in total risk, thus solve the problem, the determination of discount rate, or asset pricing. In addition, a windfall is the solution of modelling certainty equivalent and certainty equivalent coefficient.