Regime Switching Fractional Cointegration and Futures Hedging

28 Pages Posted: 15 Jan 2010 Last revised: 11 Feb 2010

See all articles by Hsiang-Tai Lee

Hsiang-Tai Lee

National Chi Nan University - Department of Finance

Date Written: January 14, 2010

Abstract

The article applies a Regime Switching Fractionally Integrated Error Correction Generalized Orthogonal GARCH model (RSFIEC-GO) for optimal futures hedging. RSFIEC-GO captures both the relationships of fractional cointegration and regime shifts between spot and futures returns. Empirical investigation in agricultural commodity markets reveals that RSFIEC-GO provides superior hedging effectiveness compared to its nested models in terms of variance reductions. Results of Diebold, Mariano and West (DMW) test with adjusted McCracken’s critical values also show the statistical superiority of RSFIEC-GO. This illustrates the importance of modeling simultaneously the fractional cointegration and regime shifts for dynamic futures hedging.

Keywords: Dynamic Futures Hedging, Hedge ratio, GARCH model, Markov regime switching

JEL Classification: C32, C51

Suggested Citation

Lee, Hsiang-Tai, Regime Switching Fractional Cointegration and Futures Hedging (January 14, 2010). Finance and Corporate Governance Conference 2010 Paper. Available at SSRN: https://ssrn.com/abstract=1536362 or http://dx.doi.org/10.2139/ssrn.1536362

Hsiang-Tai Lee (Contact Author)

National Chi Nan University - Department of Finance ( email )

Taiwan

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