Ross (2015) proposed a recovery theorem which uses prices of contingent claims to recover market’s expectations about underlying asset returns. His work relies on two assumptions. He assumes all uncertainty of the economy follows a finite state irreducible Markov chain and that the pricing kernel is transition independent. We first relax the first assumption and extend it to continuous-time Markov processes with general state spaces. Secondly, we show that the transition independence assumption is equivalent to assuming that the martingale component in the long-term factorization of the pricing kernel due to Hansen and Scheinkman (2009) is constant. We next extend the long-term factorization to general semimartingale economies and reveal economic implication of the long-term factorization, as well as Ross’ recovery as a special case. With these theoretical insights, we empirically estimate the long-term factorization and conduct a hypothesis test for the transition independent assumption on the US Treasury market data. Our results show that the martingale component in the long-term factorization is highly volatile and economically significant, controlling the term structure of the risk-return tradeoff in the bond market, and the transition independence assumption is rejected at very high confidence level.

Last modified

• 04/13/2018

Creator

• Likuan Qin

DOI

• https://doi.org/10.21985/N2WM49

Subject

• Industrial Engineering and Management Sciences

Keyword

• Industrial Engineering and Management Sciences

Date created

• 2017-01-01

Resource type

• Dissertation

Rights statement

• In Copyright