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Minimal Entropy and Entropic Risk Measures: A Unified Framework via Relative Entropy

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  • Moritz Sohns

    (Faculty of Economic Studies, University of Finance and Administration, 10100 Prague, Czech Republic
    Mathematical Institute, University of Oxford, Oxford OX1 2JD, UK
    Department of Mathematical Sciences, University of South Africa, Johannesburg 0003, Florida, South Africa)

Abstract

We introduce a new coherent risk measure, the minimal-entropy risk measure, which is built on the minimal-entropy σ -martingale measure—a concept inspired by the well-known minimal-entropy martingale measure used in option pricing. While the minimal-entropy martingale measure is commonly used for pricing and hedging, the minimal-entropy σ -martingale measure has not previously been studied, nor has it been analyzed as a traditional risk measure. We address this gap by clearly defining this new risk measure and examining its fundamental properties. In addition, we revisit the entropic risk measure, typically expressed through an exponential formula. We provide an alternative definition using a supremum over Kullback–Leibler divergences, making its connection to entropy clearer. We verify important properties of both risk measures, such as convexity and coherence, and extend these concepts to dynamic situations. We also illustrate their behavior in scenarios involving optimal risk transfer. Our results link entropic concepts with incomplete-market pricing and demonstrate how both risk measures share a unified entropy-based foundation.

Suggested Citation

  • Moritz Sohns, 2025. "Minimal Entropy and Entropic Risk Measures: A Unified Framework via Relative Entropy," Risks, MDPI, vol. 13(4), pages 1-27, April.
    • Handle: RePEc:gam:jrisks:v:13:y:2025:i:4:p:70-:d:1625963
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    References listed on IDEAS

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