Regime Switching Entropic Risk Measures on Crude Oil Pricing

TL;DR

This paper proposes regime switching entropic risk measures for crude oil derivatives, incorporating economic states via Markov chains, with analytical formulas and numerical analysis revealing term structure and mean reversion in convenience yields.

Contribution

It introduces a novel risk measure framework that accounts for economic regime changes using Markov chains, with explicit formulas and simulation-based insights.

Findings

Risk measures exhibit term structure behavior.

Convenience yield shows mean-reverting dynamics.

Numerical results validate the applicability of the proposed measures.

Abstract

This paper introduces a new type of risk measures, namely regime switching entropic risk measures, and study their applicability through simulations. The state of the economy is incorporated into the entropic risk formulation by using a Markov chain. Closed formulae of the risk measure are obtained for futures on crude oil derivatives. The applicability of these new types of risk measures is based on the study of the risk aversion parameter and the convenience yield. The numerical results show a term structure and a mean-reverting behavior of the convenience yield.