Arbitrage Free Dispersion

78 Pages Posted: 14 Jan 2019 Last revised: 11 Apr 2019

See all articles by Piotr Orłowski

Piotr Orłowski

HEC Montreal

Andras Sali

Alphacruncher

Fabio Trojani

Swiss Finance Institute; University of Geneva

Date Written: August 10, 2018

Abstract

We develop a theory of arbitrage-free dispersion (AFD) that characterizes the testable restrictions of asset pricing models. AFD measures Jensen’s gap in the cumulant generating function of pricing kernels and returns. It implies a wide family of model-free dispersion constraints, which extend dispersion and co-dispersion bounds in the literature and are applicable with a unifying approach in multivariate and multiperiod settings. Empirically, the dispersion of stationary and martingale pricing kernel components in the benchmark long-run risk model yields a counterfactual dependence of short- vs. long-maturity bond returns and is insufficient for pricing optimal portfolios of market equity and short-term bonds.

Keywords: Arbitrage-Free Dispersion, Cumulant Generating Function, Convexity, Convex Inequalities, Jensen’s Gap, Pricing Kernel Bounds, Entropy, Long-Run Risk Models, Tests of Asset Pricing Models

JEL Classification: G12, G15, C14, C52, C58

Suggested Citation

Orłowski, Piotr and Sali, Andras and Trojani, Fabio, Arbitrage Free Dispersion (August 10, 2018). Swiss Finance Institute Research Paper No. 19-20. Available at SSRN: https://ssrn.com/abstract=3314269 or http://dx.doi.org/10.2139/ssrn.3314269

Piotr Orłowski (Contact Author)

HEC Montreal ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

Andras Sali

Alphacruncher ( email )

Switzerland

Fabio Trojani

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva ( email )

Geneva
Switzerland

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