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What is the Consumption-CAPM missing? An information-theoretic framework for the analysis of asset pricing models

Anisha Ghosh, Christian Julliard and Alex Taylor

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We study a broad class of asset pricing models in which the stochastic discount factor (SDF) can be factorized into an observable component and a potentially unobservable, model-specific, one. Exploiting this decomposition we derive new entropy bounds that restrict the admissible regions for the SDF and its components. Without using this decomposition, to a second order approximation, entropy bounds are equivalent to the canonical Hansen-Jagannathan bounds. However, bounds based on our decomposition have higher information content, are tighter, and exploit the restriction that the SDF is a positive random variable. Our information-theoretic framework also enables us to extract a non-parametric estimate of the unobservable component of the SDF. Empirically, we find it to have a business cycle pattern, and significant correlations with both financial market crashes unrelated to economy-wide contractions, and the Fama-French factors. We apply our methodology to some leading consumption-based models, gaining new insights about their empirical performance.

Keywords: pricing kernel; stochastic discount factor; Consumption based asset pricing; entropy bounds (search for similar items in EconPapers)
JEL-codes: C52 G11 G12 G13 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2011-10-01
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http://eprints.lse.ac.uk/119061/ Open access version. (application/pdf)

Related works:
Journal Article: What Is the Consumption-CAPM Missing? An Information-Theoretic Framework for the Analysis of Asset Pricing Models (2017) Downloads
Working Paper: What is the Consumption-CAPM missing? An information-theoretic framework for the analysis of asset pricing models (2017) Downloads
Working Paper: What is the Consumption-CAPM missing? An informative-Theoretic Framework for the Analysis of Asset Pricing Models (2011) Downloads
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