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{\textendash}Frobenius matrix theory when the pricing kernel is transition independent. In this paper, we generalize the recovery theorem to continuous state spaces using Perron{\textendash}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.