Ross Recovery Theorem, Risk-Free Rates, and Risk-Neutral Returns

Abstract

This paper improves the application of the Ross Recovery Theorem by introducing implicit conditions of risk-free rates and risk-neutral returns embedded in state prices. The analysis reveals that market state prices do not follow a Markov chain. Furthermore, the recovered probabilities, derived under the assumptions of time-homogeneous transition state prices and transition-independent stochastic discount factors, provide limited additional information compared to risk-neutral probabilities.

Keywords: Ross Recovery, Risk-Free Rates, Risk-Neutral Returns, Dividend Yields, Markov Chain.