Publication details for Professor Dennis PhilipPhilip, 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.
- Publication type: Journal Article
- ISSN/ISBN: 1042-4431
- DOI: 10.1016/j.intfin.2016.03.003
- Further publication details on publisher web site
- Durham Research Online (DRO) - may include full text
Author(s) from Durham
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.