Optimal hedging in carbon emission markets using Markov regime switching models

Philip, D.; Shi, Y.

Abstract

This paper proposes a Markov regime switching framework for modeling carbon emission (CO2) allowances that combines a regime switching behavior and disequilibrium adjustments in the mean process, along with a state-dependent dynamic volatility process. We find that all regime switching based hedging strategies significantly outperform single regime hedging strategies (both in-sample and out-of-sample), with the newly proposed framework providing the greatest variance reduction and the best hedging performance. Our results indicate that risk managers using state-dependent hedge ratios to manage portfolio risks in carbon emission markets will achieve superior hedging returns.

Citation

Philip, D., & Shi, Y. (2016). Optimal hedging in carbon emission markets using Markov regime switching models. Journal of International Financial Markets, Institutions and Money, 43, 1-15. https://doi.org/10.1016/j.intfin.2016.03.003

• Journal Article Type: Article
• Acceptance Date: Mar 25, 2016
• Online Publication Date: Apr 1, 2016
• Publication Date: Jul 1, 2016
• Deposit Date: Mar 29, 2016
• Publicly Available Date: Apr 1, 2017
• Journal: Journal of International Financial Markets, Institutions and Money
• Print ISSN: 1042-4431
• Electronic ISSN: 1873-0612
• Publisher: Elsevier
• Peer Reviewed: Peer Reviewed
• Volume: 43
• Pages: 1-15
• DOI: https://doi.org/10.1016/j.intfin.2016.03.003
• Public URL: https://durham-repository.worktribe.com/output/1408350