Energy Prices Confront CAPM: Implications for Discount Rates

Xiaomei (Barbara) Chen

NCSU

What discount rate should be used for evaluating energy investments?

Discount Rate

1. Rate of time preference

2. Economic growth

3. Risk premium

1. CAPM (Capital Asset Pricing Model) helps explain commodity prices

◦Especially energy prices◦Risk premiums vary weekly

2. An unusually powerful test of CAPM

3. It matters for discounting energy investment

Three Points

1. Energy futures return:2. Risk-free asset return

3. Risk Premium: 4. Commodity beta:

5. CAPM Predicted Risk Premium:

Some Notations

Fitted Model: y = 0.17 + 1.69 x (0.09) (0.40)

Energy Futures

PropaneCrude Oil

GasolineHeating OilNatural Gas Coal

Fitted Model: y = 0.17 + 1.12 x (0.12) (0.31)

Crude Oil Futures

Crude Oil Futures

1985 1990 1995 2000 2005 2010

CAPM Predicted Risk Premium