Never a Dull Moment: Entropy Risk in Commodity Markets

48 Pages Posted: 14 Dec 2018 Last revised: 13 Dec 2019

See all articles by Fousseni Chabi-Yo

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management

Hitesh Doshi

University of Houston - C.T. Bauer College of Business

Virgilio Zurita

Baylor University

Date Written: January 28, 2019

Abstract

We develop a new approach to determine investors' risk compensations for all distributional moments of a security. Using the concept of entropy, a summary of all moments of a risky security, we derive the exact link between expected returns and their compensation for entropy risk. Entropy risk premium (ERP), the difference of entropy under the physical and risk-neutral measures, indicates the cost to financially hedge against changes in all assets' risks. We find that ERP carries significant predictive power for the cross-section of commodity returns even after removing its variance and skewness risk components.

Keywords: commodity returns; entropy; options; risk premium

JEL Classification: G12, G13

Suggested Citation

Chabi-Yo, Fousseni and Doshi, Hitesh and Zurita, Virgilio, Never a Dull Moment: Entropy Risk in Commodity Markets (January 28, 2019). Available at SSRN: https://ssrn.com/abstract=3300843 or http://dx.doi.org/10.2139/ssrn.3300843

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States

Hitesh Doshi (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Virgilio Zurita

Baylor University ( email )

Waco, TX 76798
United States

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