Certainty Equivalent

What is 'Certainty Equivalent'

Certainty equivalent is a guaranteed return that someone would accept, rather than taking a chance on a higher, but uncertain, return. If you've ever thought about leaving your job to start your own business, and potentially make more money, but decided to stay and continue drawing a salary instead, then the amount of your salary is your certainty equivalent. You might need to come up with a business idea with a higher potential payoff to be convinced to leave the security of your existing job.

BREAKING DOWN 'Certainty Equivalent'

Investments must pay a risk premium to compensate investors for the possibility that they may not get their money back. If an investor has a choice between a U.S. government bond paying 3% interest and a corporate bond paying 8% interest, and he chooses the government bond, the payoff is the certainty equivalent. The company would need to offer this particular investor a potential return of more than 8% on its bonds, to convince him to buy. Thus, a company seeking investors can use the certainty equivalent as a basis for determining how much more it needs to pay, to convince investors to consider the riskier option. The certainty equivalent will vary, because each investor has a unique risk tolerance.

RELATED TERMS
  1. Cash Equivalents

    Investment securities that are short-term, have high credit quality ...
  2. Equivalent Annual Cost - EAC

    The annual cost of owning an asset over its entire life. Equivalent ...
  3. Fixed-Rate Bond

    A bond that pays the same amount of interest for its entire duration. ...
  4. Cost Approach

    A real estate valuation method that surmises that the price someone ...
  5. Yield Equivalence

    The interest rate on a taxable security that would render a return ...
  6. Futures Equivalent

    The number of futures contracts needed to be associated with ...
Related Articles
  1. Investing Basics

    What are Cash Equivalents?

    Cash equivalents are money market instruments.
  2. Options & Futures

    Trade Smarter With Equivalent Positions

    Understanding the concept of equivalent positions will help you trade more efficiently and save money on trade fees.
  3. Retirement

    Equity Vs. Salary: What You Need To Know (FB, GOOG)

    Equity payments are common at startup companies. Equity offers potential for a big payout but is also much riskier than a salary payment.
  4. Investing Basics

    Long-Term Planning

    Bonds have a predictable stream of income that can be used to fund future expenses for individuals and corporate pension obligations for institutions.
  5. Retirement

    Should I Invest in Bonds After I Retire?

    Yes, retirees should invest in bonds, but remember that not all bonds are safe investments. Seek the help of a financial advisor.
  6. Professionals

    Cash Equivalents and Fixed Income Securities

    FINRA/NASAA Series 65: Section 8 Cash Equivalents and Fixed Income Securities
  7. Bonds & Fixed Income

    Cash Vs. Bonds: What to Pick in Times of Uncertainty

    Learn about the benefits and drawbacks of holding cash versus investing in bonds to ensure you make the right decision about how to best safeguard your money.
  8. Bonds & Fixed Income

    3 Signs It's Time to Sell Your Bonds

    Learn about three major signals that you should sell your bonds right now, including impending interest rate hikes and bond issuer instability.
  9. Savings

    Being too Safe with Your Money Could Turn Risky

    Find out why playing it safe with your retirement savings can actually turn risky, including the basics of inflation risk and interest rate risk.
  10. Investing Basics

    Defining The 3 Types Of Investments

    Investments can be divided into three distinct groups – ownership, lending and cash equivalents.
RELATED FAQS
  1. Are mutual funds considered cash equivalents?

    Find out why only money market mutual funds are considered cash equivalents, and learn a breakdown of the different types ... Read Answer >>
  2. What's the difference between short-term investments in marketable securities and ...

    Most of the time, when an investor or analyst searches through the financial statements of a publicly traded company, he ... Read Answer >>
  3. What is the difference between proven and probable reserves in the oil and gas sector?

    Learn how those in the oil and gas sector classify oil reserves and the specific differences between proven and probable ... Read Answer >>
  4. Where do companies keep their cash?

    If you have ever looked over a company's balance sheet, you have no doubt noticed the first account under the current asset ... Read Answer >>
  5. Does working capital include salaries?

    Learn how unpaid salaries affect the calculation of the working capital, while paid salaries have no effect on the working ... Read Answer >>
  6. How does a bull market in stocks affect the bond market?

    Take a deeper look at the relationship between the bond market and equities, and see what might happen to bonds during the ... Read Answer >>
Hot Definitions
  1. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  2. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  6. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
Trading Center