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An information-theoretic asset pricing model

Author

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

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

  • Ghosh, Anisha & Julliard, Christian & Taylor, Alex. P, 2025. "An information-theoretic asset pricing model," LSE Research Online Documents on Economics 126155, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:126155
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    File URL: http://eprints.lse.ac.uk/126155/
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    More about this item

    Keywords

    pricing kernal; relative entropy; cross-sectional asset pricing; factor models; factor mimicking portfolios; alpha;
    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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