Misspecified Recovery

52 Pages Posted: 25 May 2014 Last revised: 22 Apr 2019

See all articles by Jaroslav Borovička

Jaroslav Borovička

New York University (NYU) - Department of Economics; National Bureau of Economic Research (NBER)

Lars Peter Hansen

University of Chicago - Department of Economics; National Bureau of Economic Research (NBER)

José A. Scheinkman

Columbia University; Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 4 versions of this paper

Date Written: October 1, 2015

Abstract

Asset prices contain information about the probability distribution of future states and the stochastic discounting of those states as used by investors. To better understand the challenge in distinguishing investors' beliefs from risk-adjusted discounting, we use Perron-Frobenius Theory to isolate a positive martingale component of the stochastic discount factor process. This component recovers a probability measure that absorbs long-term risk adjustments. When the martingale is not degenerate, surmising that this recovered probability captures investors' beliefs distorts inference about risk-return tradeoffs. Stochastic discount factors in many structural models of asset prices have empirically relevant martingale components.

Keywords: Perron-Frobenius theory, recovery theorem, stochastic discount factor, martingale decomposition, stochastic stability

JEL Classification: G00, G12, D84

Suggested Citation

Borovička, Jaroslav and Hansen, Lars Peter and Scheinkman, José, Misspecified Recovery (October 1, 2015). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2441376 or http://dx.doi.org/10.2139/ssrn.2441376

Jaroslav Borovička

New York University (NYU) - Department of Economics ( email )

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National Bureau of Economic Research (NBER) ( email )

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Lars Peter Hansen (Contact Author)

University of Chicago - Department of Economics ( email )

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José Scheinkman

Columbia University ( email )

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Princeton University - Department of Economics ( email )

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