I found this setion of core reading a little confusing. I should note that I could do the deflators questions in CT8 but we were never expected to understand their use. I have 2 questions It states that use of deflators weights cashflows according to economic characteristics emerging in the projections- what does this mean? Say a deficit arises, would a very risk averse investor place a very high (absolute) value on this and therefore discount it using a large deflator? Next it states it helps not to take credit for investment out-performance- is this done simply because the technique summmarises the distribution of outcomes using a discounted value of the full range of outcomes?
The numerical values deflators are state-specific - i.e. they differ between states and are dependent on the characterisitcs of each state (i.e. the corresponding economic conditions) in ways that are not made clear in this course and so we don't need to worry about them. Importantly, the deflator values are independent of the stakeholder whose cashflows they are beiong used to value (because the deflators are state-specific and not investor-specific or asset-specific). Using deflators means that we don't take advance credit for the higher returns on equities, which we would do if we used a higher discount rate to value liabilities simply because those liabilities are backed by equity investments (doing this would ignore the greater riskiness of equities). Deflators avoid this problem because: (1) The deflator values used to value the liabilities are independent of the assets chosen to back the liabilities. (2) Using a DCF valuation based on deflators enables us to allow for the shareholders' option to default on pensions promises (by not contributing to the pension fund should things turn out badly and the company goes bust)
