What Does Certainty Equivalent Mean?
Certainty equivalent can be defined as the lowest cash amount that will compensate an investor participating in a risky oil and gas venture whose outcome is uncertain. Investments pay a risk premium in order to compensate investors in case the expected outcome is not achieved. The investor accepts an agreed amount of guaranteed cash instead of taking the risk of receiving a greater return at a later date, keeping in mind that the venture may not yield expected results.
Trenchlesspedia Explains Certainty Equivalent
Certainty equivalent varies based on an individual's attitude towards risk taking because it will depend on an individual’s financial capacity to risk an investment. The difference between the certainty equivalent and the amount paid by an organization to investors willing to take the risk in an uncertain investment is known as the risk differential. Companies use certainty equivalent to determine how much it needs to pay investors in order to convince them to make the risky investment.
Certainty equivalent is calculated as expected cash flow / (1 + risk premium).