Optimal hedging in carbon emission markets using Markov regime switching models
Dennis Philip and
Journal of International Financial Markets, Institutions and Money, 2016, vol. 43, issue C, 1-15
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.
Keywords: Carbon emission markets; Dynamic hedging; Markov switching models; Dynamic conditional correlation (search for similar items in EconPapers)
JEL-codes: G13 G32 Q47 (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:intfin:v:43:y:2016:i:c:p:1-15
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