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What Is the Consumption-CAPM Missing? An Information-Theoretic Framework for the Analysis of Asset Pricing Models

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  • Anisha Ghosh
  • Christian Julliard
  • Alex P. Taylor

Abstract

We consider asset pricing models in which the SDF can be factorized into an observable component and a potentially unobservable one. Using a relative entropy minimization approach, we nonparametrically estimate the SDF and its components. Empirically, we find the SDF has a business-cycle pattern and significant correlations with market crashes and the Fama-French factors. Moreover, we derive novel bounds for the SDF that are tighter and have higher information content than existing ones. We show that commonly used consumption-based SDFs correlate poorly with the estimated one, require high risk aversion to satisfy the bounds and understate market crash risk.Received December 19, 2012; editorial decision January 17, 2016 by Editor Pietro Veronesi.

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  • Anisha Ghosh & Christian Julliard & Alex P. Taylor, 2017. "What Is the Consumption-CAPM Missing? An Information-Theoretic Framework for the Analysis of Asset Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 30(2), pages 442-504.
  • Handle: RePEc:oup:rfinst:v:30:y:2017:i:2:p:442-504.
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    4. Liu, Yan, 2021. "Index option returns and generalized entropy bounds," Journal of Financial Economics, Elsevier, vol. 139(3), pages 1015-1036.
    5. A. Ronald Gallant & George Tauchen, 2021. "Cash Flows Discounted Using a Model-Free SDF Extracted under a Yield Curve Prior," JRFM, MDPI, vol. 14(3), pages 1-15, March.
    6. Pietro Murialdo & Linda Ponta & Anna Carbone, 2020. "Long-Range Dependence in Financial Markets: a Moving Average Cluster Entropy Approach," Papers 2004.14736, arXiv.org.
    7. Nikolay Gospodinov & Esfandiar Maasoumi, 2017. "General Aggregation of Misspecified Asset Pricing Models," FRB Atlanta Working Paper 2017-10, Federal Reserve Bank of Atlanta.
    8. Weidong Tian, 2021. "Long Run Law and Entropy," Papers 2111.06238, arXiv.org.
    9. Qiu, Chen & Otsu, Taisuke, 2021. "Information theoretic approach to high dimensional multiplicative models: stochastic discount factor and treatment effect," LSE Research Online Documents on Economics 110494, London School of Economics and Political Science, LSE Library.
    10. Amit K. Sinha, 2021. "The reliability of geometric Brownian motion forecasts of S&P500 index values," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 40(8), pages 1444-1462, December.
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    More about this item

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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