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Modeling carbon spot and futures price returns with GARCH and Markov switching GARCH models

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  • Alexander Zeitlberger

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  • Alexander Brauneis

Abstract

This paper makes use of spot and futures market data to carry out a thorough analysis of the dynamics of carbon price returns in the European Union Emission Trading Scheme for the whole first commitment period from 2008 to 2012. Understanding the properties of carbon price returns is especially crucial for industries which have to comply with an emission trading system and other market participants such as risk managers and speculators. We therefore seek to develop accurate models which capture the behavior of carbon price returns comprehensively. We apply a broad spectrum of GARCH model specifications, using different distributions for model innovations. As both time series, spot and futures price returns, exhibit asymmetric behavior in their variance, we additionally take Markov regime switching models for the variance equation into consideration. Empirical results demonstrate that AGARCH, NARCH and GJR fit the data best. We further show that, in the error term of any model, fat-tailed distributions—in particular the generalized error distribution—significantly improve the fit. Additionally, as futures returns seem to carry informational content concerning subsequent spot returns, we propose a sound, yet parsimonious, spot returns model, well-suited to capturing the dynamics. Finally, the most appropriate models for spot and futures price returns are tested in an out-of-sample environment, and further checked for robustness in data subsets. Subsequently a model for each market is proposed. Copyright Springer-Verlag Berlin Heidelberg 2016

Suggested Citation

  • Alexander Zeitlberger & Alexander Brauneis, 2016. "Modeling carbon spot and futures price returns with GARCH and Markov switching GARCH models," Central European Journal of Operations Research, Springer;Slovak Society for Operations Research;Hungarian Operational Research Society;Czech Society for Operations Research;Österr. Gesellschaft für Operations Research (ÖGOR);Slovenian Society Informatika - Section for Operational Research;Croatian Operational Research Society, vol. 24(1), pages 149-176, March.
  • Handle: RePEc:spr:cejnor:v:24:y:2016:i:1:p:149-176
    DOI: 10.1007/s10100-014-0340-0
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