The Recovery Theorem
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.
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