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

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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 moment estimations