Sources of Entropy in Representative Agent Models

58 Pages Posted: 20 Jul 2011

See all articles by David K. Backus

David K. Backus

NYU Stern School of Business; National Bureau of Economic Research (NBER)

Mikhail Chernov

UCLA Anderson

Stanley E. Zin

Leonard N. Stern School of Business - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: July 2011

Abstract

We propose two metrics for asset pricing models and apply them to representative agent models with recursive preferences, habits, and jumps. The metrics describe the pricing kernel’s dispersion (the entropy of the title) and dynamics (time dependence, a measure of how entropy varies over different time horizons). We show how each model generates entropy and time dependence and compare their magnitudes to estimates derived from asset returns. This exercise -- and transparent loglinear approximations -- clarifies the mechanisms underlying these models. It also reveals, in some cases, tension between entropy, which should be large enough to account for observed excess returns, and time dependence, which should be small enough to account for mean yield spreads.

Keywords: asset returns, bond yields, disasters, habits, jumps, pricing kernel, recursive preferences

JEL Classification: E44, G12

Suggested Citation

Backus, David K. and Chernov, Mikhail and Zin, Stanley E., Sources of Entropy in Representative Agent Models (July 2011). CEPR Discussion Paper No. DP8488. Available at SSRN: https://ssrn.com/abstract=1890011

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Mikhail Chernov

UCLA Anderson ( email )

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Stanley E. Zin

Leonard N. Stern School of Business - Department of Economics ( email )

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