Modelling the conditional volatility of commodity index futures as a regime switching process

Wai Mun Fong and Kim Hock See
Additional contact information
Wai Mun Fong: Department of Finance and Accounting, National University of Singapore, Kent Ridge Crescent, Singapore 119260, Postal: Department of Finance and Accounting, National University of Singapore, Kent Ridge Crescent, Singapore 119260
Kim Hock See: Department of Finance and Accounting, National University of Singapore, Kent Ridge Crescent, Singapore 119260, Postal: Department of Finance and Accounting, National University of Singapore, Kent Ridge Crescent, Singapore 119260

Journal of Applied Econometrics, 2001, vol. 16, issue 2, 133-163

Abstract: Commodity index futures offer a versatile tool for gaining different forms of exposure to commodity markets. Volatility is a critical input in many of these applications. This paper examines issues in modelling the conditional variance of futures returns based on the Goldman Sachs Commodity Index (GSCI). Given that commodity markets tend to be 'choppy' (Webb, 1987), a general econometric model is proposed that allows for abrupt changes or regime shifts in volatility, transition probabilities which vary explicitly with observable fundamentals such as the basis, GARCH dynamics, seasonal variations and conditional leptokurtosis. The model is applied to daily futures returns on the GSCI over 1992-1997. The results show clear evidence of regime shifts in conditional mean and volatility. Once regime shifts are accounted for, GARCH effects are minimal. Consistent with the theory of storage, returns are more likely to switch to the high-variance state when the basis is negative than when the basis is positive. The regime switching model also performs well in forecasting the daily volatility compared to standard GARCH models without regime switches. The model should be of interest to sophisticated traders who base their trading strategies on short-term volatility movements, managed commodity funds interested in hedging an underlying diversified portfolio of commodities and investors of options and other derivatives tied to GSCI futures contracts. Copyright © 2001 John Wiley & Sons, Ltd.

Date: 2001
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (23)

Downloads: (external link)
http://qed.econ.queensu.ca:80/jae/2001-v16.2/ Supporting data files and programs (text/html)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:jae:japmet:v:16:y:2001:i:2:p:133-163

Ordering information: This journal article can be ordered from
http://www3.intersci ... e.jsp?issn=0883-7252

Access Statistics for this article

Journal of Applied Econometrics is currently edited by M. Hashem Pesaran

More articles in Journal of Applied Econometrics from John Wiley & Sons, Ltd.
Bibliographic data for series maintained by Wiley-Blackwell Digital Licensing () and Christopher F. Baum ().