Does the Ross Recovery Theorem Work Empirically?

63 Pages Posted: 24 Jul 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: July 24, 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, stochastic discount factor, risk-neutral density, transition state prices, physical probabilities

Suggested Citation

Jackwerth, Jens Carsten and Menner, Marco, Does the Ross Recovery Theorem Work Empirically? (July 24, 2018). 31st Australasian Finance and Banking Conference 2018, Available at SSRN: https://ssrn.com/abstract=3218922

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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