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New Entropy Restrictions and the Quest for Better-Specified Asset-Pricing Models

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  • Bakshi, Gurdip
  • Chabi-Yo, Fousseni

Abstract

This article proposes the entropy of m2 (m is the stochastic discount factor) as a metric to evaluate asset-pricing models. We develop a bound on the entropy of m2 when m correctly prices a finite number of returns and consider models that pass the lower bound on m, yet fail the lower bound on m2. Interpreting our results, we elaborate on the distinction between the entropy of m2 versus the entropy of m. We further show that the entropy of m2 represents an upper bound on the expected excess (log) return of the security with the payoff of m.

Suggested Citation

  • Bakshi, Gurdip & Chabi-Yo, Fousseni, 2019. "New Entropy Restrictions and the Quest for Better-Specified Asset-Pricing Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 54(6), pages 2517-2541, December.
    • Handle: RePEc:cup:jfinqa:v:54:y:2019:i:6:p:2517-2541_8
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    Cited by:

    1. Chen, Dongxu & Wu, Ke & Zhu, Yifeng, 2022. "Stock return asymmetry in China," Pacific-Basin Finance Journal, Elsevier, vol. 73(C).
    2. Liu, Yan, 2021. "Index option returns and generalized entropy bounds," Journal of Financial Economics, Elsevier, vol. 139(3), pages 1015-1036.

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