Certainty equivalent definition
/What is the Certainty Equivalent?
The certainty equivalent is that amount of guaranteed cash that a person would accept instead of taking the risk of receiving a larger amount at a later date. The difference between the certainty equivalent and the amount an organization must pay investors for the use of their money is this risk differential. The certainty equivalent varies by investor, since each person has a different tolerance for risk. For example, a person approaching retirement is more likely to have a high certainty equivalent, since he is less willing to put his retirement funds at risk. This means that a business looking for funds can target those investors with a more modest certainty equivalent, which results in a lower cost of funds for the firm.
Example of the Certainty Equivalent
As an example of the certainty equivalent, when a startup company must pay investors a 15% return when the yield on a U.S. Treasury issuance is 2%, this means that investors must be paid the 13% differential because they perceive the investment to be a risky one. Conversely, a more established firm with a record of consistently generating profits might only have to pay investors an 8% return, since they perceive the entity’s ability to pay back funds to be much less risky than that of the startup company.