Jurnal of Finance - Misspecified Recovery PDF
JAROSLAV BOROVIČKA,LARS PETER HANSEN,JOSÉ
A. SCHEINKMAN
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.
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