Working Paper: CEPR ID: DP8488
Authors: David Backus; Mikhail Chernov; Stanley E. Zin
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 Codes: E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Entropy of the pricing kernel (G19) | Mean excess returns (G12) |
| Dynamics of the pricing kernel (G19) | Yield behavior (D21) |
| Jumps in consumption growth (E20) | Entropy of the pricing kernel (G19) |
| Entropy of the pricing kernel (G19) | Yield spreads (E43) |