Why Does the Recovery Theorem Not Work Empirically? An Intrinsic Explanation

24 Pages Posted: 2 Jul 2020 Last revised: 3 Aug 2020

See all articles by Shengbo Zhu

Shengbo Zhu

Pennsylvania State University, College of the Liberal Arts - Department of Economic

Date Written: August 1, 2020

Abstract

Ross (2015) shows an elegant recovery theorem but follow-up papers show it does not work empirically. BHS (2016) proposes an explanation: the transition-independent assumption is equivalent to setting the martingale component to be 1. However, I argue that the transition-independent assumption is unlikely to be the reason for the empirical failure. What causes the empirical failure is the time-homogeneous state-price matrix. In particular, when the underlying price is used as the state variable, this implies an eigenvalue equation that contradicts the eigenvalue equation in Ross (2015), which makes the recovery theorem not just empirically implausible, but also logically inconsistent.

Keywords: Ross Recovery Theorem, Hansen-Scheinkman Decomposition, Martingale Condition, State Price, Intrinsic Inconsistency

JEL Classification: G00, G13, G12

Suggested Citation

Zhu, Shengbo, Why Does the Recovery Theorem Not Work Empirically? An Intrinsic Explanation (August 1, 2020). Available at SSRN: https://ssrn.com/abstract=3623423 or http://dx.doi.org/10.2139/ssrn.3623423

Shengbo Zhu (Contact Author)

Pennsylvania State University, College of the Liberal Arts - Department of Economic ( email )

524 Kern Graduate Building
University Park, PA 16802-3306
United States

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