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Maximum Entropy Analysis of Consumption-based Capital Asset Pricing Model and Volatility

Author

Listed:
  • Lee Tae-Hwy

    (Department of Economics, University of California, Riverside, CA, 92521, USA)

  • Mao Millie Yi

    (Department of Mathematics, Physics and Statistics, Azusa Pacific University, Azusa, CA, 91702, USA)

  • Ullah Aman

    (Department of Economics, University of California, Riverside, CA, 92521, USA)

Abstract

Based on the maximum entropy (ME) method, we introduce an information theoretic approach to estimating conditional moment functions with incorporating a theoretical constraint implied from the consumption-based capital asset pricing model (CCAPM). Using the ME conditional mean/variance functions obtained from the ME density, we analyze the relationship between asset returns and consumption growth under the theoretical constraint of the CCAPM. We evaluate the predictability of asset return using consumption growth through in-sample estimation and out-of-sample prediction in the ME mean regression function. We also examine the ME variance regression function for the asset return volatility as a function of the consumption growth. Our findings suggest that incorporating the CCAPM constraint can capture the nonlinear predictability of asset returns in mean especially in tails, and that the consumption growth has an effect on reducing stock return volatility, indicating the counter-cyclical variation of stock market volatility.

Suggested Citation

  • Lee Tae-Hwy & Mao Millie Yi & Ullah Aman, 2021. "Maximum Entropy Analysis of Consumption-based Capital Asset Pricing Model and Volatility," Journal of Econometric Methods, De Gruyter, vol. 10(1), pages 1-19, January.
    • Handle: RePEc:bpj:jecome:v:10:y:2021:i:1:p:1-19:n:2
    DOI: 10.1515/jem-2019-0022
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    Cited by:

    1. Subhadeep Mukhopadhyay, 2023. "Abductive Inference and C. S. Peirce: 150 Years Later," Journal of Quantitative Economics, Springer;The Indian Econometric Society (TIES), vol. 21(1), pages 123-149, March.
    2. Michael William Ashby & Oliver Bruce Linton, 2024. "Do Consumption-Based Asset Pricing Models Explain the Dynamics of Stock Market Returns?," JRFM, MDPI, vol. 17(2), pages 1-42, February.

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    More about this item

    Keywords

    information theory; stock return and consumption growth; CCAPM theoretical constraint; ME mean regression function; ME variance regression function;
    All these keywords.

    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • G1 - Financial Economics - - General Financial Markets

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