This article discusses how to calculate certainty equivalent. There is always uncertainty in life. We don’t know what is going to happen next. We always expect something favorable from us. Investors invest their valuable shares because of this. They desire to get more income by investing. This is a risky process. Sometimes the situation might be favorable to you.
In some circumstances, investors are forced to accept a lesser amount because of this uncertainty. The certainty equivalent definition simply means the lesser amount the investor would accept to refuse to enter an event. In the event, the investor may receive a higher amount. Instead of taking a risk, the investor would drop his decision.
The certainty equivalence helps you to evaluate the risk. Investors have every right to get their return for the risk they take. The investor can expect more return if his risk is higher. The risk tolerance of individuals varies. Some people are ready to take any risk in their life. A person who is going to retire will not be ready to put their fund at risk.
When and how to calculate certainty equivalent?
Here we will discuss the certainty equivalent calculation with an example.
- Think that you are planning to do a business. You are planning to invest fifty thousand
- You are expecting a profit of four lakh. But there is a fifty /fifty chance
- Sometimes you may lose the whole amount and gain nothing
- In this circumstance, if one of your friends gets ready to take over the business. However, for an amount that is favorable to you.
- Moreover, he will take up the risk and invest the money. You will be getting a certain amount.
- If you are ready for this deal then in economics this amount is certainly equivalent
- Your insurance payment is a practical example of how to calculate certainty equivalent
- Another example is that you are planning to buy a car. In the next five years if something happens then you have to pay a huge amount
- So the dealer may ask you to pay an amount to extend the warranty. Moreover, if something happens then the warrant amount will help you
- But it is uncertain that if something worse will happen or not
- However, if nothing happens the amount you pay to the dealer is a loss.
- This is absolutely gambling and this is how to find certainty equivalent.
How to calculate certainty equivalent?
If you deny the proposal of your friend. However, it is necessary to sell your business too. You have some confusion regarding the exact amount of price to sell out your business. However, you have to demand a higher amount than your friend’s proposal. So here comes the need for a certainty equivalent formula.
The equivalent formula is expressed as the cash flow of the investment. The absolute equivalent cash flow is the risk-free cash flow. Which seems to match the higher but higher-risk expected cash flow.
Formula: Expected cash flow/(1 + risk premium)
Where the risk premium is the risk-adjusted interest rate, which is lower than the risk-free interest rate. The risk-adjusted interest rate is the required rate of return on investment. We also use this ratio for discounting the company’s cash flow to its present value.
Calculation of certainty by an example
Let’s look at an example of how to calculate certainty equivalent. The investors can choose to accept a cash flow of CU15,000.
Or choose another option with the following expectations:
30% chance to get 15,000 rupees
50% chance to get 31,000 rupees
20% chance to get 8,000 rupees
This is the expected rate:
30% * 15,000 = 4,500 rupees
50% * 31,000 = 15,500 rupees
20% * 8000 = 1600 rupees
Total = Rs 21,600
Now, assume that the risk alteration rate is 10% and the risk-free rate is 2%.
The risk premium is 8% (10% lower than 2).
The equation we get = 21,600 rupees / (1 + 10%) = 19,636 rupees.
Based on this calculation, if investors choose to avoid risk, they should accept Rs 19,636 instead of Rs 15,000.
Uses of certainty equivalent
- Firstly it helps in evaluating the risk to the customer
- Secondly, it helps the company in attracting investors to buy their bonds.
- The companies will get an idea about how much price they have to offer to attract the customers
- By considering these you should know how to calculate certainty equivalent
Advantages of certainty equivalent
The advantages of certainty equivalence are the following:-
- Firstly, the calculation is very simple.
- Secondly, it identifies risks by changing risky cash flows.
- Finally, this is useful when comparing multiple project estimates.
- That means, multiple decision-making, is based upon the probability of a combination of NPVs occurring.
Some of the disadvantages of certainty equivalent
The certainty equivalent has the following limitations:-
- Firstly, the implementation of certainty equivalence is very difficult in actual practice.
- Secondly, this method depends on management’s preference for profit.
- And, also depends on investors’ intuitive acceptance of investors.
- Because the same is a subjective assessment. That is, it may not be objective, accurate or consistent.
- Third, the probability distribution of possible cash flows is not confirmed.
- Finally, sometimes the forecasting has to go through several levels of management.
- In this case, the original forecast may exaggerate.
What information does the certainty equality gives you
- The investment must pay a risk premium to compensate investors for the possibility of not being able to recover their funds.
- The higher the risk, the higher the investor’s expected premium relative to the average return.
So this article will help to know how to calculate certainty equivalent. Make use of this method and avoid your risk. In the present situation, there is much software available for certainty equivalent calculation. The decision tree software is one such famous software. The software will help you to calculate certainty in no time. However, there will be uncertainty in life. But only those who take risks will be successful.
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