The Recovery Theorem
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 ma...
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| Format: | Article |
| Language: | en_US |
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American Finance Association/Wiley
2015
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| Online Access: | http://hdl.handle.net/1721.1/99126 https://orcid.org/0000-0001-8894-5217 |
| Summary: | 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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