The Recovery Theorem

58 Pages Posted: 29 Aug 2011

See all articles by Stephen A. Ross

Stephen A. Ross

Massachusetts Institute of Technology (MIT) - Sloan School of Management; Yale University - International Center for Finance

Multiple version iconThere are 2 versions of this paper

Date Written: August 2011

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.

Suggested Citation

Ross, Stephen A., The Recovery Theorem (August 2011). NBER Working Paper No. w17323. Available at SSRN: https://ssrn.com/abstract=1918653

Stephen A. Ross (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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Yale University - International Center for Finance

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