Abstract
Relationship between risk and return is the most important concern in finance. It is well known that market expectations of risk are embedded in option prices. However, due to the success of risk-neutral pricing theory, option prices are silent in predicting natural probability of return. Therefore, S. Ross proposes an intuitive method, Recovery Theorem, to recover the natural probability distribution under a discrete-time setting. This work aims to conduct empirical test of index options based on Ross’s Recovery Theorem, and applies Recovery Theorem in Black-Litterman portfolio optimization model.