Modeling the Joint Dynamics of Spot and Futures Markets with a Regime Switching Long Memory Volatility Process
42 Pages Posted: 22 Aug 2011
Date Written: August 22, 2011
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
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