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The Recovery Theorem
Author(s) -
ROSS STEVE
Publication year - 2015
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12092
Subject(s) - stochastic discount factor , economics , econometrics , risk aversion (psychology) , kernel density estimation , risk premium , financial economics , stock (firearms) , distribution (mathematics) , probability distribution , capital asset pricing model , mathematics , expected utility hypothesis , statistics , estimator , mechanical engineering , engineering , mathematical analysis
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.