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Optimal futures hedging under jump switching dynamics

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  • Lee, Hsiang-Tai
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    Abstract

    The article develops a Markov regime switching Generalized Orthogonal GARCH model with conditional jump dynamics (JSGO) for optimal futures hedging. To the author's knowledge, there is no existing study on dynamic futures hedging investigating both the effects of regime switching and conditional jumps. This might be the fact that there is no existing hedging model encompassing both of these features. The JSGO solves this problem by introducing a jump switching filtering algorithm to infer ex post both the distributions of jumps and state variables and a recombining procedure to solve the path-dependency problem. To justify the usefulness of the JSGO on dynamic futures hedging, hedging exercises are performed using FTSE 100 futures data traded in the London International Financial Futures and Options Exchange (LIFFE). JSGO exhibits good out-of-sample performance compared to its jump-free and state-independent counterparts in terms of both criteria of variance reductions and utility improvements.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Empirical Finance.

    Volume (Year): 16 (2009)
    Issue (Month): 3 (June)
    Pages: 446-456

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    Handle: RePEc:eee:empfin:v:16:y:2009:i:3:p:446-456

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    Web page: http://www.elsevier.com/locate/jempfin

    Related research

    Keywords: Hedging Hedge ratio GARCH model Markov regime switching;

    References

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    1. Gray, Stephen F., 1996. "Modeling the conditional distribution of interest rates as a regime-switching process," Journal of Financial Economics, Elsevier, vol. 42(1), pages 27-62, September.
    2. Tse, Y K & Tsui, Albert K C, 2002. "A Multivariate Generalized Autoregressive Conditional Heteroscedasticity Model with Time-Varying Correlations," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(3), pages 351-62, July.
    3. Giorgio Valente & Lucio Sarno, 2004. "Empirical Exchange Rate Models and Currency Risk: Some Evidence from Density Forecasts," Working Papers wp04-10, Warwick Business School, Finance Group.
    4. Baillie, Richard T & Myers, Robert J, 1991. "Bivariate GARCH Estimation of the Optimal Commodity Futures Hedge," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 6(2), pages 109-24, April-Jun.
    5. Sarno, Lucio & Giorgio Valente, 2002. "Modelling and Forecasting Stock Returns: Exploiting the Futures Market, Regime Shifts and International Spillovers," Royal Economic Society Annual Conference 2002 160, Royal Economic Society.
    6. Hamilton, James D. & Susmel, Raul, 1994. "Autoregressive conditional heteroskedasticity and changes in regime," Journal of Econometrics, Elsevier, vol. 64(1-2), pages 307-333.
    7. H. N. E. BystrOm, 2003. "The hedging performance of electricity futures on the Nordic power exchange," Applied Economics, Taylor & Francis Journals, vol. 35(1), pages 1-11.
    8. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
    9. Chan, Wing H & Maheu, John M, 2002. "Conditional Jump Dynamics in Stock Market Returns," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(3), pages 377-89, July.
    10. Kroner, Kenneth F. & Sultan, Jahangir, 1993. "Time-Varying Distributions and Dynamic Hedging with Foreign Currency Futures," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(04), pages 535-551, December.
    11. Roy van der Weide, 2002. "GO-GARCH: a multivariate generalized orthogonal GARCH model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 17(5), pages 549-564.
    12. Chris Brooks & Olan T. Henry & Gita Persand, 2002. "The Effect of Asymmetries on Optimal Hedge Ratios," The Journal of Business, University of Chicago Press, vol. 75(2), pages 333-352, April.
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    Cited by:
    1. Thomas Conlon & John Cotter & Ramazan Gencay, 2012. "Commodity futures hedging, risk aversion and the hedging horizon," Working Papers 201218, Geary Institute, University College Dublin.
    2. Fu, Junhui & Zhang, Wei-Guo & Yao, Zheng & Zhang, Xili, 2012. "Hedging the portfolio of raw materials and the commodity under the mark-to-market risk," Economic Modelling, Elsevier, vol. 29(4), pages 1070-1075.
    3. Fu, Junhui, 2014. "Multi-objective hedging model with the third central moment and the capital budget," Economic Modelling, Elsevier, vol. 36(C), pages 213-219.
    4. Pascal François & Geneviève Gauthier & Frédéric Godin, 2012. "Optimal Hedging when the Underlying Asset Follows a Regime-switching Markov Process," Cahiers de recherche 1234, CIRPEE.
    5. Lee, Hsiang-Tai, 2010. "Regime switching correlation hedging," Journal of Banking & Finance, Elsevier, vol. 34(11), pages 2728-2741, November.

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