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J. Risk Financial Manag. 2015, 8(1), 2-16; doi:10.3390/jrfm8010002

State Prices and Implementation of the Recovery Theorem

Department of Actuarial Science and the African Collaboration for Quantitative Finance and Risk Research, University of Cape Town, Rondebosch, Cape Town 7700, South Africa
Academic Editor: Michael McAleer
Received: 29 October 2014 / Revised: 1 December 2014 / Accepted: 5 January 2015 / Published: 19 January 2015
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Abstract

It is generally held that derivative prices do not contain useful predictive information, that is, information relating to the distribution of future financial variables under the real-world measure. This is because the market’s implicit forecast of the future becomes entangled with market risk preferences during derivative price formation. A result derived by Ross [1], however, recovers the real-world distribution of an equity index, requiring only current prices and mild restrictions on risk preferences. In addition to being of great interest to the theorist, the potential practical value of the result is considerable. This paper addresses implementation of the Ross Recovery Theorem. The theorem is formalised, extended, proved and discussed. Obstacles to application are identified and a workable implementation methodology is developed. View Full-Text
Keywords: Recovery Theorem; Ross recovery; real-world measure; predictive information; state prices; state-price matrix Recovery Theorem; Ross recovery; real-world measure; predictive information; state prices; state-price matrix
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This is an open access article distributed under the Creative Commons Attribution License which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. (CC BY 4.0).

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Backwell, A. State Prices and Implementation of the Recovery Theorem. J. Risk Financial Manag. 2015, 8, 2-16.

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