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Optimal hedging in carbon emission markets using Markov regime switching models

Dennis Philip and Yukun Shi

Journal of International Financial Markets, Institutions and Money, 2016, vol. 43, issue C, 1-15

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.

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)
Date: 2016
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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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