The Recovery Theorem

Authors

  • STEVE ROSS

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    • 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, Steve Heston, Patrick Dennis, the referee, Associate Editor, and the Editor. All errors are my own. I also wish to thank the participants in the AQR Insight Award and AQR for its support.


ABSTRACT

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, and probability of a catastrophe and to construct model-free tests of the efficient market hypothesis.

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