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.
The author is a Managing Partner of Ross Farrar,LLC,, a Registered Investment Adviser that manages portfolios of derivative securities including options. The data used in the paper were obtained under a non-disclosure agreement with a financial firm. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.