Working Paper: CEPR ID: DP12665
Authors: David Lando; Lasse Heje Pedersen; Christian Skov Jensen
Abstract: We characterize when physical probabilities, marginal utilities, and the discount rate can be recovered from observed state prices for several future time periods. We make no assumptions of the probability distribution, thus generalizing the time-homogeneous stationary model of Ross (2015). Recovery is feasible when the number of maturities with observable prices is higher than the number of states of the economy (or the number of parameters characterizing the pricing kernel). When recovery is feasible, our model is easy to implement, allowing a closed-form linearized solution. We implement our model empirically, testing the predictive power of the recovered expected return and other recovered statistics.
Keywords: asset pricing; theory; financial economics; pricing kernel; risk aversion
JEL Codes: G00; G1; G12; G13; G17
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| number of maturities with observable prices (t) (G19) | recovery is feasible (P27) |
| recovery is feasible (P27) | ability to recover marginal utilities and discount rates (D11) |
| model structure (C52) | recovery process (H12) |
| model assumptions (C51) | recovery outcomes (I12) |
| recovered expected returns (G17) | future actual returns (G17) |
| global financial crisis (F65) | predictability of recovered expected returns (G17) |