Arbitrage-Based Recovery

33 Pages Posted: 28 Jul 2021

See all articles by Ferenc Horvath

Ferenc Horvath

City University of Hong Kong (CityU)

Date Written: July 5, 2021

Abstract

We develop a novel recovery theorem based on no-arbitrage principles. Our Arbitrage-Based Recovery Theorem does not require assuming time homogeneity of either the physical probabilities, the Arrow-Debreu prices, or the stochastic discount factor; and it requires the observation of Arrow-Debreu prices only for one single maturity. We perform several different density tests and mean prediction tests using 25 years of S&P 500 options data, and we find evidence that our method can correctly recover the probability distribution of the S&P 500 index level on a monthly horizon.

Keywords: recovery theorem, physical probabilities, transition state prices, stochastic discount factor, no-arbitrage

JEL Classification: G1, G12, G13, G17

Suggested Citation

Horvath, Ferenc, Arbitrage-Based Recovery (July 5, 2021). Available at SSRN: https://ssrn.com/abstract=3880921 or http://dx.doi.org/10.2139/ssrn.3880921

Ferenc Horvath (Contact Author)

City University of Hong Kong (CityU) ( email )

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