Modeling the Joint Dynamics of Spot and Futures Markets with a Regime Switching Long Memory Volatility Process

42 Pages Posted: 22 Aug 2011

See all articles by Jonathan Dark

Jonathan Dark

University of Melbourne; Financial Research Network (FIRN)

Date Written: August 22, 2011

Abstract

The methods used to model the dynamics of spot and futures markets ignore the effects of changes in the cost of carry (COC) on the dynamics of the basis and its rate of convergence. This is of particular importance given the historically low short term interest rates currently experienced in many countries. This paper proposes a bivariate model that exhibits long memory in volatility, basis convergence and regime switches that occur via a latent markov process. Monte carlo simulation reveals that the model parameters can be well estimated via maximum likelihood. The proposed model is supported by applications to equity and currency markets. It is found that regime switches in basis dynamics occur between high and low volatility states associated with high and low absolute values of the COC. In and out of sample forecasts generally support the proposed model, however minimum variance hedge ratio estimation provides mixed support.

Keywords: long memory, regime switching, dynamic futures hedging, cost of carry

Suggested Citation

Dark, Jonathan, Modeling the Joint Dynamics of Spot and Futures Markets with a Regime Switching Long Memory Volatility Process (August 22, 2011). 24th Australasian Finance and Banking Conference 2011 Paper. Available at SSRN: https://ssrn.com/abstract=1914223 or http://dx.doi.org/10.2139/ssrn.1914223

Jonathan Dark (Contact Author)

University of Melbourne ( email )

185 Pelham Street
Carlton, Victoria 3053
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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