Misspecified Recovery

Jaroslav BoroviČka, Lars Peter Hansen, JosÉ A. Scheinkman

    Research output: Contribution to journalArticlepeer-review

    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.

    Original languageEnglish (US)
    Pages (from-to)2493-2544
    Number of pages52
    JournalJournal of Finance
    Volume71
    Issue number6
    DOIs
    StatePublished - Dec 1 2016

    ASJC Scopus subject areas

    • Accounting
    • Finance
    • Economics and Econometrics

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