Never a Dull Moment: Entropy Risk in Commodity Markets
50 Pages Posted: 14 Dec 2018 Last revised: 6 Feb 2019
Date Written: January 28, 2019
We examine the role of entropy risk in explaining the cross-section of commodity returns motivated by a theoretical model. We show that the commodity's entropy, a summary of all higher moments of returns, captures the dispersion of the stochastic discount factor and therefore affects expected excess returns. We compute entropy risk premiums as the difference between the physical and risk-neutral measures of entropy, estimated from the commodity futures and options market. We form entropy-based portfolios, and find that commodities with high ex-ante entropy risk premium have higher subsequent returns. The results from the strategy hold after controlling for variance and skewness risk premiums, and are robust to global and commodity specific risk factors.
Keywords: commodity returns; entropy; options; risk premium
JEL Classification: G12, G13
Suggested Citation: Suggested Citation