Why Does the Recovery Theorem Not Work Empirically? An Intrinsic Explanation
24 Pages Posted: 2 Jul 2020 Last revised: 3 Aug 2020
Date Written: August 1, 2020
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: Suggested Citation