Never a Dull Moment: Entropy Risk in Commodity Markets

Abstract

Abstract We develop a new approach to determine investors’ risk compensations for all distributional moments of a security. Using the concept of entropy, which is a summary of all moments of a risky security, we derive the relationship between expected returns and their compensation for entropy risk. Entropy risk premium (ERP), which is entropy under the physical minus the risk-neutral measure, indicates the hedging cost against changes in risks associated with all moments of the return’s distribution. Applying our model to the commodity markets, we find that ERP carries economically significant information for the cross-section of returns that is different from individual or combined moments. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.