Optimal hedging in carbon emission markets using Markov regime switching models

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

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.

• Item Type: Articles
• Status: Published
• Refereed: Yes
• Glasgow Author(s) Enlighten ID: Shi, Dr Yukun
• Authors: Philip, D., and Shi, Y.
• College/School: College of Social Sciences > Adam Smith Business School > Accounting and Finance
• Journal Name: Journal of International Financial Markets, Institutions and Money
• Publisher: Elsevier
• ISSN: 1042-4431
• ISSN (Online): 1042-4431
• Published Online: 01 April 2016
• Copyright Holders: Copyright © 2016 Elsevier B.V.
• First Published: First published in Journal of International Financial Markets, Institutions and Money 43:1-15
• Publisher Policy: Reproduced in accordance with the copyright policy of the publisher