Title: The Ross recovery theorem and the term structure of interest rates
Authors: Liangyi Mu - Queen's Management School (United Kingdom) [presenting]
Abstract: An omitted risk-free rate condition in Ross recovery estimation is proposed. The term structure of risk-free rates explains the differences between approaches of Ross recovery estimations and the original Ross recovery. A flat term structure of risk-free rates results in a Ross recovered probability distribution identical to the risk-neutral probability distribution in Ross recovery. After considering risk-free rates with a market example, empirical evidence still shows Ross recovered probability distribution is close to the risk-neutral probability distribution. Besides, some challenges with Ross recovery empirical applications are presented. Ross recovery with a short transition time implies a nonnegative matrix root for the transition matrix with a long transition time. Different least squares estimations are not equivalent when there is no unique and accurate fitting with the market state prices. A sparse spot state price surface probably results in a relatively stable pricing kernel in Ross recovery.