Examining the Feasibility of the Sturm–Liouville Theory for Ross Recovery

• Main Authors: Shinmi Ahn, Hyungbin Park
• Format: Article
• Language: English
• Published: MDPI AG 2020-04-01
• Series: Mathematics
• Subjects: Ross recovery; Sturm–Liouville theory; physical measure; risk-neutral measure; pricing kernel; Markov process
• Online Access: https://www.mdpi.com/2227-7390/8/4/550

Recent studies have suggested that it is feasible to recover a physical measure from a risk-neutral measure. Given a market state variable modeled as a Markov process, the key concept is to extract a unique positive eigenfunction of the generator of the Markov process. In this work, the feasibility of this recovery theory is examined. We prove that, under a restrictive integrability condition, recovery is feasible if and only if both endpoints of the state variable are limit-point. Several examples with explicit positive eigenfunctions are considered. However, in general, a physical measure cannot be recovered from a risk-neutral measure. We provide a financial and mathematical rationale for such recovery failure.