15/12/2019 Certainty Equivalent Definition

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Certainty Equivalent Definition

REVIEWED BY WILL KENTON | Updated Apr 21, 2019

What Is the Certainty Equivalent?

The certainty equivalent is a guaranteed return that someone would accept now, rather than
taking a chance on a higher, but uncertain, return in the future. Put another way, the
certainty equivalent is the guaranteed amount of cash that a person would consider as
having the same amount of desirability as a risky asset.

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What Does the Certainty Equivalent Tell You?

Investments must pay a risk premium to compensate investors for the possibility that they
may not get their money back and the higher the risk, the higher premium an investor
expects over the average return.

If an investor has a choice between a U.S. government bond paying 3% interest and a
corporate bond paying 8% interest and he chooses the government bond, the payoff
differential is the certainty equivalent. The corporation would need to offer this particular
investor a potential return of more than 8% on its bonds to convince him to buy.

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A company seeking investors can use the certainty equivalent as a basis for determining how
much more it needs to pay to convince investors to consider the riskier option. The certainty
equivalent varies because each investor has a unique risk tolerance.

The term is also used in gambling, to represent the amount of payoff someone would require
to be indifferent between it and a given gamble. This is called the gamble's certainty
equivalent.

The certainty equivalent represents the amount of guaranteed money an investor

would accept now instead of taking a risk of getting more money at a future date
The certainty equivalent varies between investors based on their risk tolerance, and
a retiree would have a higher certainty equivalent because he's less willing to risk
his retirement funds
The certainty equivalent is closely related to the concept of risk premium or the
amount of additional return an investor requires to choose a risky investment over
a safer investment

Example of How to Use the Certainty Equivalent

The idea of certainty equivalent can be applied to cash flow from an investment. The
certainty equivalent cash flow is the risk-free cash flow that an investor or manager
considers equal to a different expected cash flow which is higher, but also riskier. The
formula for calculating the certainty equivalent cash flow is as follows:

Expected cash flow
Certainty equivalent cash flow = (1+risk premium)

The risk premium is calculated as the risk-adjusted rate of return minus the risk-free rate. The
expected cash flow is calculated by taking the probability-weighted dollar value of each
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expected cash flow and adding them up.

For example, imagine that an investor has the choice to accept a guaranteed $10 million cash
inflow or an option with the following expectations:

A 30% chance of receiving $7.5 million

A 50% chance of receiving $15.5 million
A 20% chance of receiving $4 million

Based on these probabilities, the expected cash flow of this scenario is:

Expected cash flow = 0.3 ∗ $7.5 million + 0.5 ∗ $15.5 million + 0.2 ∗ $4 mil

= $10.8 million

Assume the risk-adjusted rate of return used to discount this option is 12% and the risk-free
rate is 3%. Thus, the risk premium is (12% - 3%), or 9%. Using the above equation, the
certainty equivalent cash flow is:

$10.8 million
Certainty equivalent cash flow =
(1 + 0.09)
= $9.908 million

Based on this, if the investor prefers to avoid risk, he should accept any guaranteed option
worth more than $9.908 million.

Related Terms
Forward Price Definition
The predetermined delivery price of a forward contract, as agreed on and calculated by the buyer and
seller. more

Perpetuity Definition
Perpetuity, in finance, is a constant stream of identical cash flows with no end. An example of a
financial instrument with perpetual cash flows is the consol. more

What Is the Macaulay Duration?

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The Macaulay duration is the weighted average term to maturity of the cash flows from a bond. more

How a Forward Rate Agreement – FRA Hedges Interest Rates

Forward rate agreements (FRA) are over-the-counter contracts between parties that determine the
rate of interest to be paid on an agreed upon date in the future. more

How Equivalent Annual Cost Helps with Capital Budget Decisions

Equivalent annual cost (EAC) is the annual cost of owning, operating, and maintaining an asset over its
entire life. EAC is often used by firms for capital budgeting decisions, as it allows a company to
compare the cost-effectiveness of various assets that have unequal lifespans. more

Modified Duration
Modified duration is a formula that expresses the measurable change in the value of a security in
response to a change in interest rates. more

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