Which is the Correct Discount Rate? Arithmetic Versus Geometric Mean
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Which is the Correct Discount Rate? Arithmetic Versus Geometric Mean
Kipp, Martin | Koziol, Christian
Credit and Capital Markets – Kredit und Kapital, Vol. 53 (2020), Iss. 3 : pp. 355–381
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Martin Kipp, M.Sc., University of Tuebingen, Department of Finance, Nauklerstr. 47, 72074 Tuebingen, Phone: +49 7071 29 78176
Prof. Dr. Christian Koziol, University of Tuebingen, Department of Finance, Nauklerstr. 47, 72074 Tuebingen
References
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Huang, C.-f./Litzenberger, R. H. (1988): Foundations for Financial Economics, Prentice Hall.
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Hull, J. C. (2017): Options, Futures, and Other Derivatives, 9th ed., Pearson.
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Koller, T./Goedhart, M./Wessels, D. (2015): Valuation: Measuring and Managing the Value of Companies, 6th edition, John Wiley & Sons.
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KPMG (2019): Cost of Capital Study 2019, 14th ed.
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Tsay, R. S. (2005): Analysis of Financial Time Series, Vol. 543, John Wiley & Sons.
Google Scholar -
Black, F./Scholes, M. (1973): The Pricing of Options and Corporate Liabilities, Journal of Political Economy, Vol. 81(3), 637–654.
Google Scholar -
Brealey, R./Myers, S. C./Allen, F. (2011): Principles of Corporate Finance, 10th ed., McGraw-Hill.
Google Scholar -
Cochrane, J. H. (2009): Asset pricing: Revised Edition, Princeton University Press.
Google Scholar -
Cornish, E. A./Fisher, R. A. (1938): Moments and Cumulants in the Speci?cation of Distributions, Revue de l’Institut international de Statistique, 307–320.
Google Scholar -
Damodaran, A. (2013): Equity Risk Premiums (ERP): Determinants, Estimation and Implications – the 2012 edition’, Managing and Measuring Risk: Emerging Global Standards and Regulations after the Financial Crisis, 343–455.
Google Scholar -
Dor?eitner, G. (2002): Stetige versus diskrete Renditen: Überlegungen zur richtigen Verwendung beider Begri?e in Theorie und Praxis, Kredit und Kapital, Vol. 35, 216–241.
Google Scholar -
Dor?eitner, G. (2003): Why the return notion matters, International Journal of Theoretical and Applied Finance, Vol. 6(1), 73–86.
Google Scholar -
European Commission (2014): Regulation (EU) no 1286/2014 of the European Parliament and of the Council of 26 November 2014 on Key Information Documents for Packaged Retail and Insurance-based Investment Products (PRIIPs). URL: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32014R1286
Google Scholar -
European Commission (2017): Commission delegated Regulation (EU) 2017/653 of 8 March 2017 Supplementing Regulation (EU) no 1286/2014 of the European Parliament and of the Council on Key Information Documents for Packaged Retail and Insurance-based Investment Products (PRIIPs) by laying down Regulatory Technical Standards with regard to the Presentation, Content, Review and Revision of Key Information Documents and the Conditions for ful?lling the Requirement to provide such Documents. URL: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32017R0653
Google Scholar -
Graf, S. (2019): PRIIP-KID: Providing Retail Investors with Inappropriate Product Information?, European Actuarial Journal, Vol. 9(2), 361–385.
Google Scholar -
Huang, C.-f./Litzenberger, R. H. (1988): Foundations for Financial Economics, Prentice Hall.
Google Scholar -
Hull, J. C. (2017): Options, Futures, and Other Derivatives, 9th ed., Pearson.
Google Scholar -
Koller, T./Goedhart, M./Wessels, D. (2015): Valuation: Measuring and Managing the Value of Companies, 6th edition, John Wiley & Sons.
Google Scholar -
KPMG (2019): Cost of Capital Study 2019, 14th ed.
Google Scholar -
May, S. (2019): Arithmetische und geometrische versus diskrete und stetige Renditen, Working Papers, Technische Hochschule Ingolstadt.
Google Scholar -
Stehle, R. (2004): Die Festlegung der Risikoprämie von Aktien im Rahmen der Schätzung des Wertes von börsennotierten Kapitalgesellschaften, Die Wirtschaftsprüfung, Vol. 57(17), 906–927.
Google Scholar -
Tsay, R. S. (2005): Analysis of Financial Time Series, Vol. 543, John Wiley & Sons.
Google Scholar
Abstract
The paper revisits the two major concepts for average historical returns, i.?e., the arithmetic mean and the geometric mean, in order to clarify which approach must be used for which application. Conducting a rigorous derivation with a geometric Brownian motion, we can explain that the appropriate discount rate refers to the mean discrete return and, therefore, to the arithmetic mean rather than the often wrongly applied geometric mean. Likewise, the prominent CAPM relationship between the expected asset return and the expected market return is only valid for the arithmetic mean rather than the geometric mean. Using historical data for the German stock index, we illustrate that an inconsistent application can cause severe deviations from the meaningful ex-ante expected performance of an asset, the true discount rate, the true CAPM risk-adjusted return, and the intended performance scenarios of packaged retail and insurance-based investment products (PRIIPs) within the key information documents (KIDs).