A Recovery that We Can Trust? Deducing and Testing the Restrictions of the Recovery Theorem

Abstract

How reliable is the recovery theorem of Ross (2015)? We explore this question in the context of options on the 30-year Treasury bond futures, allowing us to deduce restrictions that link the physical and risk-neutral return distributions. Our empirical results undermine the implications of the recovery theorem. First, we reject an implicit assumption of the recovery theorem that the martingale component of the stochastic discount factor is identical to unity. Second, we consider the restrictions between the physical and risk-neutral return moments when the recovery theorem holds, and reject them in both forecasting regressions and generalized method of moments estimations. Received November 7, 2016; editorial decision July 24, 2017 by Editor Stijn Van Nieuwerburgh. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.