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Optimal hedging in carbon emission markets using Markov regime switching models.

Philip, D. and Shi, Y. (2016) 'Optimal hedging in carbon emission markets using Markov regime switching models.', Journal of international financial markets, institutions and money., 43 . pp. 1-15.


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.

Item Type:Article
Full text:(AM) Accepted Manuscript
Available under License - Creative Commons Attribution Non-commercial No Derivatives.
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Publisher statement:© 2016 This manuscript version is made available under the CC-BY-NC-ND 4.0 license
Date accepted:25 March 2016
Date deposited:29 March 2016
Date of first online publication:01 April 2016
Date first made open access:01 April 2017

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