Ross is with the Sloan School, MIT. I want to thank the participants in the UCLA Finance workshop for their insightful comments as well as Richard Roll, Hanno Lustig, Rick Antle, Andrew Jeffrey, Peter Carr, Kevin Atteson, Jessica Wachter, Ian Martin, Leonid Kogan, Torben Andersen, John Cochrane, Dimitris Papanikolaou, William Mullins, Jon Ingersoll, Jerry Hausman, Andy Lo, Steve Leroy, George Skiadopoulos, Xavier Gabaix, Patrick Dennis, Phil Dybvig, Will Mullins, Nicolas Caramp, Rodrigo Adao, the referee, associate editor, and the editor. All errors are my own.
The Recovery Theorem
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This article has been accepted for publication and undergone full peer review but has not been through the copyediting, typesetting, pagination and proofreading process which may lead to differences between this version and the Version of Record. Please cite this article as doi: 10.1111/jofi.12092.
- Accepted manuscript online: 12 AUG 2013 07:22AM EST
- Manuscript Accepted: 28 JUN 2013
- Manuscript Received: 8 NOV 2011
- Cited By
We can only estimate the distribution of stock returns, but from option prices we observe the distribution of state prices. State prices are the product of risk aversion – the pricing kernel – and the natural probability distribution. The Recovery Theorem enables us to separate these to determine the market's forecast of returns and risk aversion from state prices alone. Among other things, this allows us to recover the pricing kernel, market risk premium, probability of a catastrophe, and to construct model-free tests of the efficient market hypothesis.
This article is protected by copyright. All rights reserved.