Title

Misspecified Recovery

Author(s)

Jaroslav Borovicka Jaroslav Borovicka (New York University)

Lars Peter Hansen Lars Hansen (University of Chicago and NBER)

Jose A. Scheinkman Jose 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.

Creation Date

2015-10

Section URL ID

Paper Number

063_2014

URL

http://www.borovicka.org/files/research/misspecified_recovery.pdf

File Function

Jel

D83, G12

Keyword(s)

Suppress

false

Series

10