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Misspecified Recovery

Author

Listed:
  • Jaroslav Borovicka

    (New York University)

  • Lars Peter Hansen

    (University of Chicago and NBER)

  • Jose A. Scheinkman

    (Columbia University, Princeton University and NBER)

Abstract

Asset prices contain information about the probability distribution of future states and the stochastic discounting of those states as used by investors. To better understand the challenge in distinguishing investors' beliefs from risk-adjusted discounting, we use Perron-Frobenius Theory to isolate a positive martingale component of the stochastic discount factor process. This component recovers a probability measure that absorbs long-term risk adjustments. When the martingale is not degenerate, surmising that this recovered probability captures investors' beliefs distorts inference about risk-return tradeoffs. Stochastic discount factors in many structural models of asset prices have empirically relevant martingale components.

Suggested Citation

  • Jaroslav Borovicka & Lars Peter Hansen & Jose A. Scheinkman, 2015. "Misspecified Recovery," Working Papers 063_2014, Princeton University, Department of Economics, Econometric Research Program..
  • Handle: RePEc:pri:metric:063_2014
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    References listed on IDEAS

    as
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    Citations

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    as


    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:wly:emetrp:v:85:y:2017:i::p:1219-1238 is not listed on IDEAS
    3. Hyungbin Park, 2015. "Sensitivity Analysis of Long-Term Cash Flows," Papers 1511.03744, arXiv.org.
    4. repec:eee:macchp:v2-1641 is not listed on IDEAS
    5. Kubler, Felix & Polemarchakis, Herakles, 2015. "The identification of beliefs from asset demand," The Warwick Economics Research Paper Series (TWERPS) 1087, University of Warwick, Department of Economics.
    6. Borovicka, J. & Hansen, L.P., 2016. "Term Structure of Uncertainty in the Macroeconomy," Handbook of Macroeconomics, Elsevier.
    7. Hyungbin Park, 2015. "The Martin Integral Representation of Markovian Pricing Kernels," Papers 1504.00276, arXiv.org.
    8. Lasse Pedersen & David Lando & Christian Skov Jensen, 2016. "Generalized Recovery," 2016 Meeting Papers 935, Society for Economic Dynamics.
    9. Jihun Han & Hyungbin Park, 2014. "The Intrinsic Bounds on the Risk Premium of Markovian Pricing Kernels," Papers 1411.4606, arXiv.org, revised Sep 2015.
    10. Hyungbin Park, 2014. "Ross Recovery with Recurrent and Transient Processes," Papers 1410.2282, arXiv.org, revised Oct 2015.
    11. Brinkmann, Felix & Korn, Olaf, 2014. "Risk-adjusted option-implied moments," CFR Working Papers 14-07, University of Cologne, Centre for Financial Research (CFR).
    12. Likuan Qin & Vadim Linetsky & Yutian Nie, 2016. "Long Forward Probabilities, Recovery and the Term Structure of Bond Risk Premiums," Papers 1601.06477, arXiv.org.
    13. 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:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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