Faculty of Economics and Business Administration Publications Database

Functional Ross recovery: Theoretical results and empirical tests

Dillschneider, Yannick
Volume: 108
Pages: 103750 -
Month: November
ISSN-Print: 0165-1889
Link External Source: Online Version
Year: 2019
Keywords: Ross recovery; Pricing kernel; State price density; Perron-Frobenius theory

Recently, Ross (2015) showed that the real-world probability distribution of a discrete Markovian state variable can be recovered from observed option prices. The so-called recovery theorem follows from Perron-Frobenius matrix theory when the pricing kernel is transition independent. In this paper, we generalize the recovery theorem to continuous state spaces using Perron-Frobenius operator theory. Building on our theoretical results, we devise a nonparametric estimation approach to empirically recover the pricing kernel and real-world probability density in closed form. Using S&P 500 index options, we analyze recovered pricing kernels empirically and find evidence that Ross recovery is misspecified.