The Recovery Theorem / Stephen A. Ross.

By:

Ross, Stephen A

Contributor(s):

National Bureau of Economic Research

Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w17323.Publication details: Cambridge, Mass. National Bureau of Economic Research 2011.Description: 1 online resource: illustrations (black and white)Subject(s):

Online resources:

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Abstract: We can only estimate the distribution of stock returns but we observe the distribution of risk neutral state prices. Risk neutral state prices are the product of risk aversion - the pricing kernel - and the natural probability distribution. The Recovery Theorem enables us to separate these and to determine the market's forecast of returns and the market's risk aversion from state prices alone. Among other things, this allows us to determine the pricing kernel, the market risk premium, the probability of a catastrophe, and to construct model free tests of the efficient market hypothesis.

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August 2011.

We can only estimate the distribution of stock returns but we observe the distribution of risk neutral state prices. Risk neutral state prices are the product of risk aversion - the pricing kernel - and the natural probability distribution. The Recovery Theorem enables us to separate these and to determine the market's forecast of returns and the market's risk aversion from state prices alone. Among other things, this allows us to determine the pricing kernel, the market risk premium, the probability of a catastrophe, and to construct model free tests of the efficient market hypothesis.