Does the Ross Recovery Theorem Work Empirically?

63 Pages Posted: 1 May 2017 Last revised: 2 Nov 2018

See all articles by Jens Carsten Jackwerth

Jens Carsten Jackwerth

University of Konstanz - Department of Economics

Marco Menner

ESADE Business School; University of Konstanz

Date Written: November 1, 2018

Abstract

Starting with the fundamental relationship that state prices are the product of physical probabilities and the stochastic discount factor, Ross (2015) shows that, given strong assumptions, knowing state prices suffices for backing out physical probabilities and the stochastic discount factor at the same time. We find that such recovered physical distributions based on the S&P 500 index are incompatible with future realized returns and fail to predict realized returns and variances. These negative results remain even when we add economically reasonable constraints. Simple benchmark methods based on a power utility agent or on the historical return distribution cannot be rejected.

Keywords: Ross recovery, pricing kernel, risk-neutral density, transition state prices, physical probabilities

JEL Classification: G00, G12, G13

Suggested Citation

Jackwerth, Jens Carsten and Menner, Marco, Does the Ross Recovery Theorem Work Empirically? (November 1, 2018). Available at SSRN: https://ssrn.com/abstract=2960733 or http://dx.doi.org/10.2139/ssrn.2960733

Jens Carsten Jackwerth

University of Konstanz - Department of Economics ( email )

Universitaetsstr. 10
Konstanz, 78457
Germany
+497531882196 (Phone)
+497531883120 (Fax)

HOME PAGE: http://cms.uni-konstanz.de/wiwi/jackwerth/

Marco Menner (Contact Author)

ESADE Business School ( email )

Av. de Pedralbes, 60-62
Barcelona, 08034
Spain

University of Konstanz ( email )

Universit├Ątsstra├če 10
Konstanz, D-78457
Germany

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