Project specific risks, catastrophic risks and the use of risk - PowerPoint PPT Presentation

Project specific risks, catastrophic risks and the use of risk premiums Mark Freeman Accounting for the timing of costs and benefits in the evaluation of health projects relevant to LMICs 14th September 2017 Mark Freeman (University of York) Risk & Valuation September 2017 1 / 14

What is appropriate for valuing healthcare in LMICs? Risk matters Macroeconomic risk has a different valuation implication (precautionary saving) than project uncertainty (risk premium) Risk should not be measured by standard deviation alone. Higher moments matter Low probability, but potentially catastrophic, economic outcomes can significantly influence valuations Risk premiums can be negative, increasing healthcare project valuation National or international perspective? Mark Freeman (University of York) Risk & Valuation September 2017 2 / 14

Risk-free or risk-adjusted discounting? Risk-free discounting Many governments value all social projects using the simple Ramsey rule (e.g. UK for horizons < 30 years). Based on the Arrow-Lind theorem Risk-adjusted discounting Others (e.g. French, Dutch and Norwegian), explicitly allow for risk in valuation, as project benefits generally relate to the overall macro-economy (non-zero ‘beta’). Central ground Some argue that risk premiums are too small to concern us. The US discounts at 7% and 3% (2.5%, 3% & 5% climate change, 3% health). Mark Freeman (University of York) Risk & Valuation September 2017 3 / 14

Stylistic example Binomial process for consumption Current aggregate consumption c 0 = $1 , 000. Consumption in 10 years of c u (probability π ) or c d (probability 1 − π ). Parameterizing We set c u , c d and π so that future (10-year) consumption has an expectation of $1,200 with a standard deviation of $300. Vary π , let the mean and standard deviation determine c u and c d . Mark Freeman (University of York) Risk & Valuation September 2017 4 / 14

The consumption process 2,500 Consumption in the up state 2,000 Consumption in the down state Future consumption 1,500 1,000 500 Low probability of severe consumption catastrophe 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Probability of being in the up state Mark Freeman (University of York) Risk & Valuation September 2017 5 / 14

An LMIC healthcare project Another binomial process Healthcare project with monetized benefit of b u or b d in ten years: Pro-cyclical: b u occurs iff c u occurs; probability π Counter-cyclical: b u occurs iff c d occurs; probability 1 − π Also look at risk-free and acyclical projects. Parameterizing b u and b d set so the expected benefit is $2, with standard deviation to $1. They depend on π . Mark Freeman (University of York) Risk & Valuation September 2017 6 / 14

Cyclical benefits 5 benefit in up state (pro-cyclical) 4 benefit in down state (pro-cyclical) 3 Benefit 2 1 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Probability of being in the up state -1 Mark Freeman (University of York) Risk & Valuation September 2017 7 / 14

Counter-cyclical benefits - Mirror image 5 benefit in up state (counter-cyclical) benefit in down state (counter-cyclical) 4 Low probability of consumption catastrophe associated with high project 3 benefits Benefit 2 1 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Probability of being in the up state -1 Mark Freeman (University of York) Risk & Valuation September 2017 8 / 14

Valuing the healthcare project Equilibrium Social planner gets time separable utility e − ρ t U ( c t ) from aggregate consumption. In equilibrium, the present value, p , of the project: U ( c 0 − p ) + e − ρ t E [ U ( c t + b )] = U ( c 0 ) + e − ρ t E [ U ( c t )] The utility function Power utility with relative risk aversion = 2, rate of pure time preference ρ = 1%. Mark Freeman (University of York) Risk & Valuation September 2017 9 / 14

Present value of the risk-free project 3.50 3.00 PV (risk-free) Present value of the project PV (risk-free, certain consumption) 2.50 2.00 1.50 Precautionary effect gets stronger Precautionary effect increases 1.00 with catastrophic consumption price of risk-free projects outcomes (Rietz 1988, Barro 2006 & (extended Ramsey Rule) 2009, Gabaix 2012) 0.50 0.00 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Probability of being in the up state Mark Freeman (University of York) Risk & Valuation September 2017 10 / 14

Present value of the pro-cyclical & acyclical projects 3.50 PV (pro-cyclical) High sensitivity of valuation to precise 3.00 PV (independent) likelihood and outcome of catastrophe (Martin, 2013; Gollier, 2016) Present value of the project PV (risk-free) 2.50 2.00 1.50 Positive (zero) risk premium for 1.00 positive (zero) beta healthcare project (CCAPM) Risk premium high in the presence 0.50 of catastrophic risk (Rietz, 1988; Barro 2006 & 2009; Gabaix 2012) 0.00 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Probability of being in the up state Mark Freeman (University of York) Risk & Valuation September 2017 11 / 14

Present value of the counter-cyclical project 3.50 3.00 PV (counter-cyclical) Present value of the project PV (risk-free) 2.50 2.00 1.50 Projects with strong payoffs in catastrophic states are very highly Counter-cyclical projects more valued (e.g. Weitzman 2007 & highly priced than risk-free 2009, Dietz 2011, Barro 2013, 1.00 assets (CCAPM) Pindyck 2013). Discount rate here negative. 0.50 0.00 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Probability of being in the up state Mark Freeman (University of York) Risk & Valuation September 2017 12 / 14

A counter-cyclical healthcare project Healthcare projects in LMICs to protect against economic collapse Consider an LMIC that, in the event of an economic collapse (low probability event), expects a healthcare crisis (famine, malaria outbreak, etc.). Project to protect against this outcome Since this project’s benefits are greatest in catastrophic states, it has very high value. Mark Freeman (University of York) Risk & Valuation September 2017 13 / 14

What is the ‘beta’ of a healthcare project National or international perspective The probability of catastrophic economic outcomes, and the relationship with healthcare projects, within LMICs are greater/stronger on a national than international perspective. Proper international support would help mitigate national effects Therefore, when undertaking these valuations, an assessment needs to be made of the international policy response to a disaster Mark Freeman (University of York) Risk & Valuation September 2017 14 / 14