Risk, Return, and Ross Recovery

Peter Carr and Jiming Yu

Courant Institute, New York University

September 13, 2012

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P, Q, and Ross Recovery

Suppose the real-world probability measure P quanties the markets belief about the frequencies of future states. The risk-neutral probability measure Q describes futures prices of Arrow Debreu securities. In 2011, Stephen A. Ross began circulating a working paper called The Recovery Theorem. The Ross Recovery Theorem gives sucient conditions under which P can be obtained from Q.

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The Ross Recovery Theorem

Theorem 1 in Ross (2011) states that: if markets are complete, and if the utility function of the representative investor is state independent and intertemporally additively separable and: if the state variable is a time homogeneous Markov process X with a nite discrete state space, then: one can recover the real-world transition probability matrix of X from the assumed known matrix of Arrow Debreu state prices.

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Vas Ist Das?

Jiming Yu and I were intrigued by Rosss conclusion, but bothered by the restrictions on preferences that Ross made to generate it. In particular, it seems impossible to test whether a representative investors utility function is additively separable or not. Fortunately, there is a concept in the nancial literature which can be used to derive Rosss conclusion without restricting preferences. We exploit this concept to replace Rosss restrictions on preferences with restrictions on beliefs, which we believe to be more testable.

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Enter The Numeraire Portfolio

In 1990, John Long introduced the notion of a numeraire portfolio. A numeraire is any self-nancing portfolio whose price is alway positive. Long showed that if any set of assets is arbitrage-free, then there always exists a numeraire portfolio comprised of just these assets. The dening property of this numeraire portfolio is the following surprising result: If the value of the numeraire portfolio is used to deate each assets dollar price, then each deated price evolves as a martingale under the real-world probability measure.

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Intuition on the Numeraire Portfolio

The important mathematical property of the Money Market Account (MMA) is that it is a price process of bounded variation. When the MMA is used to nance all purchases and denominate all gains, then the P expected return on each asset position is usually not zero and in equilibrium would usually be ascribed to risk premium The important mathematical property of the numeraire portfolio is that it is a price process of unbounded variation. When the numeraire portfolio is used to nance all purchases and denominate all gains, then the mean gain on each asset is zero units of the numeraire portfolio. Intuitively, if one asset is expected to return more than another for whatever reason, then returns on the numeraire portfolio will be more positively correlated with the expected performer than with the laggard. As a result, neither asset outperforms the other on average, once gains are measured in units of the numeraire portfolio. Longs discovery of the numeraire portfolio lets one replace the abstract notion of an equivalent martingale measure Q with the concrete notion of portfolio value. Carr/Yu (NYU Courant) Risk, Return, and Ross Recovery September 13, 2012 6 / 30

Proof That the Numeraire Portfolio Exists

Consider an arbitrage-free economy consisting of a default-free Money Market Account (MMA) whose balance S0t grows at the stochastic short interest rate rt , and one or more risky assets with spot prices Sit , i = 1, . . . , n. These assumptions imply the existence of a martingale measure Q, equivalent to P, under which each r discounted security price, e evolves as a Q-martingale, i.e. EQ SiT Sit |Ft = , S0T S0t t [0, T ], i = 0, 1, . . . , n.
t r ds 0 s

Sit ,

Let M be the positive P martingale used to create Q from P: EP Sit MT SiT |Ft = , Mt S0T S0t t [0, T ], i = 0, 1, . . . , n.

To conserve probability, M must be a P martingale started at one.

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Proof That the Numeraire Portfolio Exists (Cond)

From the last slide, M is the positive P martingale used to create Q from P: EP MT SiT Sit |Ft = , Mt S0T S0t t [0, T ], i = 0, 1, . . . , n.

1 Fact: If M creates Q from P, then M creates P from Q. To conserve 1 probability, M must be a positive Q local martingale. Let L denote the product of the money market account S0 and this reciprocal:

Lt

S0t , Mt

for t [0, T ].

L is clearly a positive stochastic process. Since L is just the product of the 1 MMA and the Q local martingale M , L grows in Q expectation at the risk-free rate. As result, L is the value of some self-nancing portfolio. Multiplying both sides of the top equation by Mt and substituting in L implies: Sit SiT EP |Ft = , t [0, T ], i = 0, 1, . . . , n. LT Lt In words, L is the value of the numeraire portfolio that Long introduced.
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Intuition for Positive Continuous Price Processes

To gain intuition, suppose each spot price Si is positive and has continuous sample paths over time (i.e. no jumps). The value L of the numeraire portfolio is always positive and now it would be continuous as well. Let Rit implies:
Sit Lt

be the ratio at time t of each spot price Sit to Lt . Its formula o dRit dSit dLt dSit dLt = + Rit Sit Lt Sit Lt dLt Lt
2

The last two terms are of order dt and arise due to the unbounded variation of the sample paths of L.

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Intuition for Positive Continuous Price Processes (Cond)

Recall that for the ratio Rit
Sit Lt ,

Its formula implies: o dLt Lt

2

dRit dSit dLt dSit dLt = + Rit Sit Lt Sit Lt Let rt be the spot interest rate at time t. If: EP then since L is a portfolio: EP dLt = rt + Lt dLt Lt
2

dSit dSit dLt = rt + , Sit Sit Lt

and so taking expected value in the top equation implies: EP dRit = rt rt = 0. Rit

Hence, the ratio Rit Sit is a P local martingale. By restricting asset Lt volatilities the stronger condition of martingality can be achieved.
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Risk and Return for Each Spot Price

Suppose we furthermore assume that the market is complete. This would arise if for example each spot price is a diusion driven by a common state variable X . If we know the joint dynamics of spot prices under Q and if we can determine the dynamics of L under Q, then we can determine the real world expected return on each asset since: EP dSit dSit dLt = rt + . Sit Sit Lt

In a continuous world, the quadratic variations and covariations of martingale components under P are the same as under Q . In a continuous setting, the bounded variation components ( = expected returns) under P arise by adding the short rate r to the covariations dSitit dLtt . S L So for continuous semi-martingales, the dynamics of each spot price under P would be determined.

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Risk and Return for the Numeraire Portfolio

Recall that Long showed in a continuous setting that the risk premium of the numeraire portfolio IS its instantaneous variance rate. EP dLt = rt + Lt dLt Lt
2

One could not imagine a simpler relation between risk premium and risk. Suppose we let denote the instantaneous lognormal volatility of the numeraire portfolio, i.e. 2 dLt = 2 dt Lt Then the market price of Brownian risk is t . Our goal is now to determine this volatility, which represents both risk and reward.

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Rolling Our Own

Using Longs numeraire portfolio, we replace Rosss restrictions on the form of preferences with our restrictions on the form of beliefs. More precisely, we suppose that the prices of some given set of assets are all driven by a univariate time-homogenous bounded diusion process, X . Letting L denote the value of the numeraire portfolio for these assets, we furthermore assume that L is also driven by X and t and that (X , L) is a bivariate time homogenous diusion. We show that these assumptions determine the real world dynamics of all assets in the given set.

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Our Assumptions
We assume no arbitrage for some nite set of assets which includes a money market account (MMA). As a result, there exists a risk-neutral measure Q under which prices deated by the MMA evolve as martingales. Under Q, the driver X is a time homogeneous bounded diusion: dXt = b(Xt )dt + a(Xt )dWt , t [0, T ].

where X0 ( , u) and where W is standard Brownian motion under Q. dLt = r (Xt )dt + (Xt )dWt , Lt

We also assume that under Q, the value L of the numeraire portfolio solves: t [0, T ].

We know the functions b(x), a(x), and r (x) but not (x). How to nd it?

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Value Function of the Numeraire Portfolio

Recalling that X is our driver, we assume: Lt L(Xt , t), t [0, T ],

where L(x, t) is a positive function of x R and time t [0, T ]. Applying Its formula, the volatility of L is: o (x) 1 L(x, t)a(x) = a(x) ln L(x, t). L(x, t) x x

Dividing by a(x) > 0 and integrating w.r.t. x:

x

ln L(x, t) =

(y ) dy + f (t), where f (t) is the constant of integration. a(y )

Exponentiating implies that the value of the numeraire portfolio separates multiplicatively into a positive function () of the driver X and a positive function p() of time t: L(x, t) = (x)p(t), where: (x) = e
Carr/Yu (NYU Courant)
x (y ) dy a(y )

and p(t) = e f (t) .

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Separation of Variables
The numeraire portfolio value function L(x, t) must solve a PDE to be self-nancing: a2 (x) 2 L(x, t) + L(x, t) + b(x) L(x, t) = r (x)L(x, t). t 2 x 2 x On the other hand, the last slide shows that this value separates as: L(x, t) = (x)p(t). Using Bernoullis classical separation of variables argument, we know that: p(t) = p(0)e t , and that: a2 (x) (x) + b(x) (x) r (x)(x) = (x), 2 x [ , u].

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Regular Sturm Liouville Problem

Recall the ODE on the last slide: a2 (x) (x) + b(x) (x) r (x)(x) = (x), 2 x [ , u].

Here (x) and are unknown. This can be regarded as a regular Sturm Liouville problem. From Sturm Liouville theory, we know that there exists an eigenvalue 0 , smaller than all of the other eigenvalues, and an associated positive eigenfunction, (x) which is unique up to positive scaling. All of the eigenfunctions associated to the other eigenvalues switch signs at least once. One can numerically solve for both the smallest eigenvalue 0 and its associated positive eigenfunction, (x). The positive eigenfunction (x) is unique up to positive scaling.

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Value Function of the Numeraire Portfolio

Recall that 0 is the known lowest eigenvalue and (x) is the associated eigenfunction, positive and known up to a positive scale factor. As a result, the value function of the numeraire portfolio is also known up to a positive scale factor: L(x, t) = (x)e 0 t , x [ , u], t [0, T ].

As a result, the volatility of the numeraire portfolio is uniquely determined as: (x) = a(x) ln (x), x [ , u]. x Mission accomplished! Lets see what the market believes.

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Real World Dynamics of the Numeraire Portfolio

In our diusion setting, Long (1990) showed that the real world dynamics of L are given by: dLt = [r (Xt ) + 2 (Xt )]dt + (Xt )dBt , Lt t 0,

where B is a standard Brownian motion under the real world probability measure P. In equilibrium, the risk premium of the numeraire portfolio is simply 2 (x). Since we have determined (x) on the last slide, the risk premium of the numeraire portfolio has also been uniquely determined. The market price of Brownian risk is simply (Xt ). The function (x) is now known but what about the dynamics of X ?

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Real World Dynamics of the Driver

From Girsanovs theorem, the dynamics of the driver X under the real world probability measure P are: dXt = [b(Xt ) + (Xt )a(Xt )]dt + a(Xt )dBt , t 0,

where recall B is a standard Brownian motion under the real world probability measure P. Hence, we know the real world dynamics of the driver X . We still have to determine the real world transition density of the driver X .

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Real World Transition PDF of the Driver

From the change of numeraire theorem, the Radon Nikodym derivative dP = e dQ
T 0

dP dQ

is:

r (Xt )dt

L(XT , T ) (XT ) 0 T = e e L(X0 , 0) (X0 )

T 0

r (Xt )dt

since L(x, t) = (x)e 0 t . Let dA e 0 pricing density:

T

r (Xt )dt

dQ denote the assumed known Arrow Debreu state (XT ) 0 T e dA. (X0 )

dP =

(XT ) 0 T e e (X0 )

T 0

r (Xt )dt

dQ =

As we know the function (y ) , the positive function e T , and the Arrow (x) Debreu state pricing density dA, we know dP, the real-world transition PDF of X .

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Real World Dynamics of Spot Prices

Also from Girsanovs theorem, the dynamics of the ith spot price Sit under P are uniquely determined as: dSit = [r (Xt )Si (Xt , t)+(Xt ) Si (Xt , t)a2 (Xt )]dt+ Si (Xt , t)a(Xt )dBt , x x

where for x ( , u), t [0, T ], Si (x, t) solves the following linear PDE: a2 (x) 2 Si (x, t) + S (x, t) + b(x) Si (x, t) = r (x)Si (x, t), 2 i t 2 x x subject to appropriate boundary and terminal conditions. If Sit > 0, then the SDE at the top can be expressed as: dSit = r (Xt )+(Xt ) ln Si (Xt , t)a2 (Xt )]dt+ ln Si (Xt , t)a(Xt )dBt , t 0. Sit x x In equilibrium, the instantaneous risk premium is just d ln Si , ln L t , i.e. the increment of the quadratic covariation of returns on Si with returns on L.
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Some Extensions to Diusions on Unbounded Domain

Our results thus far apply only to diusions on bounded domains. Hence, our results thus far cant be used to determine whether one can uniquely determine P in models like Black Scholes (1973) and Cox Ingersoll Ross (1985) where the diusing state variable X lives on an unbounded domain such as (0, ). We dont yet know the general theory here, but we do know two interesting examples of it.

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Example 1: Black Scholes Model for a Stock Price

Suppose that the state variable X is a stock price whose initial value is observed to be the positive constant S0 . Suppose we assume or observe zero interest rates and dividends and we assume that the spot price is GBM under Q: dXt = dWt , Xt t 0.

Suppose only one stock option trades and from its observed market price, we learn the numerical value of . All of our previous assumptions are in place except now we have allowed the diusing state variable X to live on the unbounded domain (0, ).

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Example 1 (cond): Black Scholes Model

Recall the general ODE governing the positive function (x) and the scalar : a2 (x) (x) + b(x) (x) r (x)(x) = (x), 2 x ( , u).

In the BS model with zero rates, a2 (x) = 2 x 2 , b(x) = r (x) = 0, = 0, and u = so we want a positive function (x) and a scalar solving the Euler ODE: 2 x 2 (x) = (x), x (0, ). 2 In the class of twice dierentiable functions, there are are an uncountably innite number of eigenpairs (, ) with positive. This result implies Ross cant recover here because there are too many candidates for the value of the numeraire portfolio. However, all of the positive functions (x) are not square integrable. If we insist on this condition as well, then there are no candidates for the value of the numeraire portfolio. Ross cant recover again, but for a dierent reason.
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Example 2: Cox Ingersoll Ross (CIR) Model

The CIR model for the short interest rate r assumes the following mean-reverting square root process under Q: drt = (a + brt )dt + c rt dWt , t 0. Suppose that after calibrating to caps and oors, we get r0 = 1 , a = 1 , 2 2 b = 0 and c = 2 so that the risk-neutral short rate process is: 1 drt = dt + 2rt dWt , t 0. 2 Suppose we choose the state variable X to be the driving SBM W but started at 1. You can check that the short rate vol process 2rt is just |X |. Recall the general ODE governing the positive function (x) & the scalar : a2 (x) (x) + b(x) (x) r (x)(x) = (x), 2
2

x ( , u).

Here, a2 (x) = 1, b(x) = 0, r (x) = x2 , = , and u = so we want a positive function (x) and a scalar solving the linear ODE: 1 x2 (x) (x) = (x), 2 2
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x (, ).
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Example 2: CIR Model (Cond)

Recall we want a positive function (x) and a scalar solving the ODE: 1 x2 (x) (x) = (x), 2 2 x (, ).

This is a famous problem in quantum mechanics called quantum harmonic oscillator. Suppose we restrict the function space to be square integrable functions on the whole real line. Then the spectrum is discrete with lowest eigenvalue 0 = 1 . The associated eigenfunction (A.K.A. ground state) is the Gaussian 2 function 2 (x) = e x /2 , x (, ). The eigenfunction is clearly positive and moreover it is unique up to positive scaling, since the other eigenfunctions have the form: n (x) = hn (x)e x
2

/2

, n = 1, 2 . . . ,

x (, ),

where hn (x) is the n-th Hermite polynomial dened by the Rodrigues formula: 2 2 n hn (x) = e x /2 Dx e x /2 , n = 1, 2, . . . .
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Example 2: CIR Model (Cond)

Recall that the lowest eigenvalue is 0 = 1 and the associated ground state 2 2 is (x) = e x /2 , so we have established that the value function for the numeraire portfolio is: L(x, t) = e x
2

/2 t/2

x (, ), t 0.

Under P, Girsanovs theorem implies that the state variable X becomes the following Ornstein Uhlenbeck process: dXt = Xt dt + dBt , where B is a standard Brownian motion. Since we still have rt = r (Xt ) = 2t , the short rate is still a CIR process, but with larger mean reversion under P: drt = 1 2rt 2 dt + 2rt dBt , t 0.
X2

t 0,

In this example, Ross recovery fully succeeded and moreover we used his model!
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Summary

We highlighted Rosss Theorem 1 and propose an alternative preference-free way to derive the same nancial conclusion. Our approach is based on imposing time homogeneity on the real world dynamics of the numeraire portfolio when it is driven by a bounded time homogeneous diusion. We showed how separation of variables allows us to separate beliefs from preferences.

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Extensions

We suggest the following extensions for future research:

1 2

Extend this work to two or more driving state variables. Explore sucient conditions under which Ross recovery is possible on unbounded domains. Explore the extent to which Rosss conclusions survive when the driving process X is generalized into a semi-martingale. Explore what restrictions on P can be obtained when markets are incomplete. Implement and test.

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