Sources of Entropy in Representative Agent Models

Abstract

ABSTRACT We propose two data‐based performance measures for asset pricing models and apply them to models with recursive utility and habits. Excess returns on risky securities are reflected in the pricing kernel's dispersion and riskless bond yields are reflected in its dynamics. We measure dispersion with entropy and dynamics with horizon dependence, the difference between entropy over several periods and one. We compare their magnitudes to estimates derived from asset returns. This exercise reveals tension between a model's ability to generate one‐period entropy, which should be large, and horizon dependence, which should be small.

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