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Misspecified Recovery

Author

Listed:
  • Jaroslav Borovička
  • Lars P. Hansen
  • José A. Scheinkman

Abstract

Asset prices contain information about the probability distribution of future states and the stochastic discounting of these states. Without additional assumptions, probabilities and stochastic discounting cannot be separately identified. Ross (2013) introduced a set of assumptions that restrict the dynamics of the stochastic discount factor in a way that allows for the recovery of the underlying probabilities. We use decomposition results for stochastic discount factors from Hansen and Scheinkman (2009) to explain when this procedure leads to misspecified recovery. We also argue that the empirical evidence on asset prices indicates that the recovered measure would differ substantially from the actual probability distribution and that interpreting this measure as the true probability distribution may severely bias our inference about risk premia, investors' aversion to risk, and the welfare cost of economic fluctuations.

Suggested Citation

  • Jaroslav Borovička & Lars P. Hansen & José A. Scheinkman, 2014. "Misspecified Recovery," NBER Working Papers 20209, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:20209
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    Other versions of this item:

    • Jaroslav Boroviv{c}ka & Lars Peter Hansen & Jos'e A. Scheinkman, 2014. "Misspecified Recovery," Papers 1412.0042, arXiv.org, revised Oct 2015.
    • Jaroslav Borovicka & Lars Peter Hansen & Jose A. Scheinkman, 2015. "Misspecified Recovery," Working Papers 063_2014, Princeton University, Department of Economics, Econometric Research Program..

    References listed on IDEAS

    as
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    Citations

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    Cited by:

    1. Hansen, Lars Peter, 2013. "Uncertainty Outside and Inside Economic Models," Nobel Prize in Economics documents 2013-7, Nobel Prize Committee.
    2. repec:eee:jfinec:v:133:y:2019:i:1:p:154-174 is not listed on IDEAS
    3. repec:wly:emetrp:v:85:y:2017:i::p:1219-1238 is not listed on IDEAS
    4. Backus, David & Boyarchenko, Nina & Chernov, Mikhail, 2018. "Term structures of asset prices and returns," Journal of Financial Economics, Elsevier, vol. 129(1), pages 1-23.
    5. Hyungbin Park, 2015. "Sensitivity Analysis of Long-Term Cash Flows," Papers 1511.03744, arXiv.org, revised Sep 2018.
    6. Dmitry Levando & Maxim Sakharov, 2018. "Natural Instability of Equilibrium Prices," Working Papers 2018:01, Department of Economics, University of Venice "Ca' Foscari".
    7. repec:eee:macchp:v2-1641 is not listed on IDEAS
    8. Felix Kübler & Herakles Polemarchakis, 2017. "The Identification of Beliefs From Asset Demand," Econometrica, Econometric Society, vol. 85, pages 1219-1238, July.
    9. Borovicka, J. & Hansen, L.P., 2016. "Term Structure of Uncertainty in the Macroeconomy," Handbook of Macroeconomics, Elsevier.
    10. repec:oup:revfin:v:21:y:2017:i:4:p:1403-1444. is not listed on IDEAS
    11. Hyungbin Park, 2015. "The Martin Integral Representation of Markovian Pricing Kernels," Papers 1504.00276, arXiv.org.
    12. Lasse Pedersen & David Lando & Christian Skov Jensen, 2016. "Generalized Recovery," 2016 Meeting Papers 935, Society for Economic Dynamics.
    13. Jihun Han & Hyungbin Park, 2014. "The Intrinsic Bounds on the Risk Premium of Markovian Pricing Kernels," Papers 1411.4606, arXiv.org, revised Sep 2015.
    14. Likuan Qin & Vadim Linetsky, 2016. "Positive Eigenfunctions of Markovian Pricing Operators: Hansen-Scheinkman Factorization, Ross Recovery, and Long-Term Pricing," Operations Research, INFORMS, vol. 64(1), pages 99-117, February.
    15. Hyungbin Park, 2014. "Ross Recovery with Recurrent and Transient Processes," Papers 1410.2282, arXiv.org, revised Oct 2015.
    16. Brinkmann, Felix & Korn, Olaf, 2014. "Risk-adjusted option-implied moments," CFR Working Papers 14-07, University of Cologne, Centre for Financial Research (CFR).
    17. repec:wsi:ijtafx:v:21:y:2018:i:03:n:s0219024918500267 is not listed on IDEAS
    18. Likuan Qin & Vadim Linetsky & Yutian Nie, 2016. "Long Forward Probabilities, Recovery and the Term Structure of Bond Risk Premiums," Papers 1601.06477, arXiv.org.
    19. repec:eee:ecolet:v:174:y:2019:i:c:p:186-188 is not listed on IDEAS
    20. Han, Jihun & Park, Hyungbin, 2015. "The intrinsic bounds on the risk premium of Markovian pricing kernels," Finance Research Letters, Elsevier, vol. 13(C), pages 36-44.

    More about this item

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G0 - Financial Economics - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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