Federal credit guarantees and the problem of discount rate selection

The selection of appropriate discount rates is critical in order to account correctly for the cost of contingent liabilities in the Federal budget. If the budget is to accurately reflect the opportunity cost of resources diverted from private sector use, private risk adjusted rates must be used. Applying the logic of modern portfolio theory and the capital asset pricing model, the authors examine the problem of discount rate selection in the case of expected cash outflows in general and credit guarantees in particular. The results of the analysis show that the risk premium used to value the guarantee should be the negative of the risk premium appropriate for the asset being insured. As a first approximation, current practice of using the Treasury security rate is likely to understate the cost of mortgage credit guarantees to twenty to eighty percent.