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New Entropy Restrictions and the Quest for Better-Specified Asset-Pricing Models

Published online by Cambridge University Press:  15 November 2018

Gurdip Bakshi Open the ORCID record for Gurdip Bakshi [Opens in a new window]  and
Fousseni Chabi-Yo Open the ORCID record for Fousseni Chabi-Yo [Opens in a new window]
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Abstract

This article proposes the entropy of m2 (m is the stochastic discount factor) as a metric to evaluate asset-pricing models. We develop a bound on the entropy of m2 when m correctly prices a finite number of returns and consider models that pass the lower bound on m, yet fail the lower bound on m2. Interpreting our results, we elaborate on the distinction between the entropy of m2 versus the entropy of m. We further show that the entropy of m2 represents an upper bound on the expected excess (log) return of the security with the payoff of m.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 54 , Issue 6 , December 2019 , pp. 2517 - 2541
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

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Footnotes

1

We are deeply indebted to the referee and Jennifer Conrad (the editor) for their efforts in improving this article. The authors acknowledge helpful discussions with Ravi Bansal, Riccardo Colacito, John Crosby, Xiaohui Gao, Steve Heston, Ravi Jagannathan, Dilip Madan, George Panayotov, Leonid Kogan, Alberto Rossi, Ken Singleton, Georgios Skoulakis, Rene Stulz, Michael Stutzer, Adrien Verdelhan (2015 American Finance Association (AFA) Meeting discussant), Jessica Wachter, Jinming Xue, and Lu Zhang. Seminar participants at the University of Maryland and Ohio State University provided useful suggestions. We have also benefited from participants at the 2015 AFA Meeting and 2014 Econometric Society Meetings. Any remaining errors are our responsibility alone. All computer codes are available from the authors.

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