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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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  • Ghosh, Anisha
  • Julliard, Christian
  • Taylor, Alex. P

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.

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  • Ghosh, Anisha & Julliard, Christian & Taylor, Alex. P, 2017. "What is the Consumption-CAPM missing? An information-theoretic framework for the analysis of asset pricing models," LSE Research Online Documents on Economics 65131, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:65131
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    8. Pietro Murialdo & Linda Ponta & Anna Carbone, 2020. "Long-Range Dependence in Financial Markets: a Moving Average Cluster Entropy Approach," Papers 2004.14736, arXiv.org.
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    12. Weidong Tian, 2021. "Long Run Law and Entropy," Papers 2111.06238, arXiv.org.
    13. Qiu, Chen & Otsu, Taisuke, 2022. "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.
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    Keywords

    Pricing kernel; stochastic discount factor; consumptionbased asset pricing; entropy bounds;
    All these keywords.

    JEL classification:

    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance

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