Entropy Coherent and Entropy Convex Measures of Risk

Abstract

We introduce two subclasses of convex measures of risk, referred to as entropy coherent and entropy convex measures of risk. Entropy coherent and entropy convex measures of risk are special cases of φ-coherent and φ-convex measures of risk. Contrary to the classical use of coherent and convex measures of risk, which for a given probabilistic model entails evaluating a financial position by considering its expected loss, φ-coherent and φ-convex measures of risk evaluate a financial position under a given probabilistic model by considering its normalized expected φ-loss. We prove that (i) entropy coherent and entropy convex measures of risk are obtained by requiring φ-coherent and φ-convex measures of risk to be translation invariant; (ii) convex, entropy convex, and entropy coherent measures of risk emerge as certainty equivalents under variational, homothetic, and multiple priors preferences upon requiring the certainty equivalents to be translation invariant; and (iii) φ-convex measures of risk are certainty equivalents under variational and homothetic preferences if and only if they are convex and entropy convex measures of risk. In addition, we study the properties of entropy coherent and entropy convex measures of risk, derive their dual conjugate function, and characterize entropy coherent and entropy convex measures of risk in terms of properties of the corresponding acceptance sets.