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Durham University

Research & business

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Publication details for Professor Dennis Philip

Philip, D. & Shi, Y. (2016). Optimal hedging in carbon emission markets using Markov regime switching models. Journal of International Financial Markets, Institutions and Money 43: 1-15.

Author(s) from Durham

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.