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Paper provided by Bank of Canada in its series Working Papers with number 02-11.

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Length: 41 pages Abstract: The exponential family, relative entropy, and distortion are methods of transforming probability distributions. We establish a link between those methods, focusing on the relation between relative entropy and distortion. Relative entropy is commonly used to price risky financial assets in incomplete markets, while distortion is widely used to price insurance risks and in risk management. The link between relative entropy and distortion provides some intuition behind distorted risk measures such as value-at-risk. Furthermore, distorted risk measures that have desirable properties, such as coherence, are easily generated via relative entropy.
Date of creation: 2002
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Handle: RePEc:bca:bocawp:02-11

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Related research

Keywords: Econometric and statistical methods; Financial markets; Market structure and pricing;

Find related papers by JEL classification:
C0 - Mathematical and Quantitative Methods - - General
C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General
D8 - Microeconomics - - Information, Knowledge, and Uncertainty
G0 - Financial Economics - - General

This paper has been announced in the following NEP Reports:

• NEP-ALL-2002-07-04 (All new papers)
• NEP-FIN-2002-07-04 (Finance)
• NEP-FMK-2002-07-04 (Financial Markets)

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This page was last updated on 2009-12-22.