Dillschneider, Y. and Maurer, R. (2019). Functional Ross recovery: Theoretical results and empirical tests Journal of Economic Dynamics and Control, 108.
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Affiliated author
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Publication year2019
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JournalJournal of Economic Dynamics and Control
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 approach to empirically estimate the recovered pricing kernel and 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.