An Empirical Investigation of Recovery Theorem: Assessing Its Accuracy and Robustness in Financial Markets

Abstract

Ross (2015) proposes a method to calculate option prices in an arbitrage-free market based on the expected present value of the payoff under the risk-neutral density. However, this approach assumes strong time-homogeneity conditions. My analysis, based on the S&P 500 option index, suggests that the physical distributions recovered using this method do not align with future returns and cannot predict realized variances. I also discuss the limitations of the Recovery Theorem due to its strong assumptions and explore the economic implications of the risk-neutral densities for market-timing strategies.