Carbon Price Volatility and Financial Risk Management

20 Pages Posted: 6 Jun 2016

See all articles by Perry Sadorsky

Perry Sadorsky

York University - Schulich School of Business

Date Written: March 30, 2014

Abstract

Carbon dioxide emissions represent a new traded asset that, in addition to reducing carbon dioxide emissions through cap-and-trade initiatives, can offer financial risk diversification benefits. In this paper, multivariate generalized auto-regressive conditional heteroscedasticity (GARCH) models are used to model conditional correlations between carbon prices, oil prices, natural gas prices and stock prices. Compared with the diagonal or dynamic conditional correlation model, the constant conditional correlation model is found to fit the data the best and is used to generate hedge ratios and optimal portfolios. Carbon does not appear to be useful for hedging oil or the S&P 500 index but does seem to be useful for hedging natural gas. The average weight for the carbon/natural gas portfolio indicates that for a US$1 portfolio, 29 cents should be invested in carbon and 71 cents invested in natural gas. Hedge ratios and optimal portfolio weights vary considerably over the sample period, indicating that financial positions should be monitored frequently.

Keywords: carbon price, GARCH, price volatility

Suggested Citation

Sadorsky, Perry, Carbon Price Volatility and Financial Risk Management (March 30, 2014). Journal of Energy Markets, Vol. 7, No. 1, 2014. Available at SSRN: https://ssrn.com/abstract=2789602

Perry Sadorsky (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada

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