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Risk-discount rate vs risk-free rate

G

GeorgeFS

Keen member
Hi,

I had a question about some of the material on Page 10 of Chapter 17 Embedded Value.

It talks about how a 'risk-discount' rate may be used to discount liabilities. My understanding is that a risk-discount rate would always be higher than the risk-free rate, so does this not then mean that value of liabilities is reduced - so how is this suitable for setting aside reserves? Why would we ever want to use a higher discount rate in a valuation, surely using risk-free gives us the "worst case" and therefore most prudent scenario?

Think I may just be misunderstanding something here, any help would be great.
 
Why do you think a risk discount rate would always be higher than the risk-free rate? (It need not be, which I believe solves your confusion.)
 
Hi - actually I think your misunderstanding here relates to the context in which the term is being used. The 'risk discount rate' being referred to in this particular section of the course notes (= risk-free rate + risk margin) is being used to discount the present value of future profits part of the EV calculation (ie the PVIF), not the liabilities. (Higher discount rate -> lower PVIF)
 
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