Misspecified Recovery

52 Pages Posted: 25 May 2014 Last revised: 10 Oct 2015

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)

Jose 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, Jose A., 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 )

19 W 4th Street, 6th floor
New York, NY 10012
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
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Lars Peter Hansen (Contact Author)

University of Chicago - Department of Economics ( email )

1101 E 58th ST
Chicago, IL 60637
United States
773-702-8170 (Phone)
773-702-8490 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Jose A. Scheinkman

Columbia University ( email )

420 W. 118th Street
New York, NY 10027
United States

HOME PAGE: http://www.princeton.edu/~joses

Princeton University - Department of Economics ( email )

26 Prospect Avenue
Princeton, NJ 08544
United States
609-258-4020 (Phone)
609-258-6419 (Fax)

HOME PAGE: http://www.princeton.edu/~joses

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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