Sources of Entropy in Representative Agent Models

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.