Optimal Hedging in Carbon Emission Markets Using Markov Regime Switching Models

32 Pages Posted: 22 Apr 2015 Last revised: 13 Apr 2016

See all articles by Dennis Philip

Dennis Philip

Durham University - Department of Economics and Finance

Yukun Shi

University of Glasgow; University of Leicester

Date Written: October 17, 2014

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.

Keywords: Carbon emission markets, Dynamic hedging, Markov switching models, Dynamic conditional correlation

JEL Classification: G13, G32, Q47

Suggested Citation

Philip, Dennis and Shi, Yukun, Optimal Hedging in Carbon Emission Markets Using Markov Regime Switching Models (October 17, 2014). Journal of International Financial Markets, Institutions and Money, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2597206 or http://dx.doi.org/10.2139/ssrn.2597206

Dennis Philip (Contact Author)

Durham University - Department of Economics and Finance ( email )

Department of Economics and Finance
Mill Hill Lane
Durham, DH1 3LB
United Kingdom

Yukun Shi

University of Glasgow ( email )

Adam Smith Business School
Glasgow, Scotland G12 8LE
United Kingdom

University of Leicester ( email )

University Road
Leicester, LE1 7RH
United Kingdom

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