Working Paper: NBER ID: w17323
Authors: Stephen A. Ross
Abstract: We can only estimate the distribution of stock returns but we observe the distribution of risk neutral state prices. Risk neutral state prices are the product of risk aversion - the pricing kernel - and the natural probability distribution. The Recovery Theorem enables us to separate these and to determine the market's forecast of returns and the market's risk aversion from state prices alone. Among other things, this allows us to determine the pricing kernel, the market risk premium, the probability of a catastrophe, and to construct model free tests of the efficient market hypothesis.
Keywords: Recovery Theorem; Risk Neutral State Prices; Market Forecasts; Efficient Market Hypothesis
JEL Codes: E10; G00; G11; G12; G17
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk-neutral state prices (G19) | natural probabilities (C46) |
| risk-neutral state prices (G19) | pricing kernel (D49) |
| pricing kernel (D49) | natural measure (C52) |
| risk aversion (D81) | expected returns (G17) |
| state prices (P22) | market forecasts of returns (G17) |
| risk premium (G19) | natural expected return (G17) |
| state prices (P22) | market behavior (D40) |