Pricing kernel factorization and recovery theorem

Abstract

Recently, Ross proposed an idea, now known as the “Recovery Theorem,” that asserts that the real (physical) probability measure can be recovered from the market prices of derivatives. This work has generated a great deal of controversy in the finance literature. The purpose of this paper is to revisit the core idea of the recovery theorem and to examine its implications. In particular, issues concerning the so-called factorization of the pricing kernel will be examined from the viewpoint of the Flesaker–Hughston representation.