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An Information-Theoretic Asset Pricing Model

Author

Listed:
  • Anisha Ghosh
  • Christian Julliard
  • Alex P Taylor

Abstract

We show that a non-parametric estimate of the pricing kernel, extracted using an information-theoretic approach, delivers smaller out-of-sample pricing errors and a better cross-sectional fit than leading multi-factor models. The information stochastic discount factor (I-SDF) identifies sources of risk not captured by standard factors, generating very large annual alphas (20–37%) and Sharpe ratio (1.1). The I-SDF extracted from a wide cross-section of equity portfolios is highly positively skewed and leptokurtic, and implies that about a third of the observed risk premia represent compensation for 2.5% tail events. The I-SDF offers a powerful benchmark relative to which competing theories and investment strategies can be evaluated.

Suggested Citation

  • Anisha Ghosh & Christian Julliard & Alex P Taylor, 2025. "An Information-Theoretic Asset Pricing Model," Journal of Financial Econometrics, Oxford University Press, vol. 23(1), pages 499-547.
    • Handle: RePEc:oup:jfinec:v:23:y:2025:i:1:p:499-547.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbae033
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    More about this item

    Keywords

    alpha; cross-sectional asset pricing; factor mimicking portfolios; factor models; pricing kernel; relative entropy;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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