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

43 Pages Posted: 19 Mar 2011

See all articles by Anisha Ghosh

Anisha Ghosh

McGill University

Christian Julliard

London School of Economics & Political Science (LSE) - Department of Finance; Centre for Economic Policy Research (CEPR)

Alex P. Taylor

Alliance Manchester Business School

Date Written: March 15, 2011

Abstract

We study a broad class of asset pricing models in which the stochastic discount factor (SDF) can be factorized into an observable component (e.g., a parametric function of consumption) and a potentially unobservable one (e.g., habit level or the return on total wealth). Exploiting this decomposition we derive new entropy bounds that restrict the admissible regions for the SDF and its components. Without using this decomposition, we show that, 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 generally tighter, and naturally exploit the restriction that the SDF is a positive random variable. In addition, our information-theoretic framework enables us to extract a non-parametric estimate of the unobservable component of the SDF. Empirically we find that this component, in addition to following a clear business cycle pattern, has significant correlation with financial market crashes unrelated to economy-wide contractions. We apply our methodology to the leading consumption-based asset pricing models, gaining new insights about their empirical performance and finding empirical support for the Long Run Risk framework.

Keywords: Entropy Bounds, Multiplicative Decomposition of Pricing Kernel

JEL Classification: G12, E44

Suggested Citation

Ghosh, Anisha and Julliard, Christian and Taylor, Alex P., What is the Consumption-CAPM Missing? An Information-Theoretic Framework for the Analysis of Asset Pricing Models (March 15, 2011). AFA 2012 Chicago Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1786493 or http://dx.doi.org/10.2139/ssrn.1786493

Anisha Ghosh (Contact Author)

McGill University ( email )

1001 Sherbrooke St. W
Montreal, Quebec H3A 1G5
Canada

Christian Julliard

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Alex P. Taylor

Alliance Manchester Business School ( email )

Crawford House
Oxford Road
Manchester M13 9PL
United Kingdom

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