Abstract
This paper presents trend prediction results based on backtesting of the European Union Emissions Trading Scheme futures market. This is based on the Intercontinental Exchange from 2005 to 2019. An alternative trend prediction strategy is taken that is predicated on an application of the Fractal Market Hypothesis (FMH) in order to develop an indicator that is predictive of short term future behaviour. To achieve this, we consider that a change in the polarity of the Lyapunov-to-Volatility Ratio precedes an associated change in the trend of the European Union Allowances (EUAs) price signal. The application of the FMH in this case is demonstrated to provide a useful tool in order to assess the likelihood of the market becoming bear or bull dominant, thereby helping to inform carbon trading investment decisions. Under specific conditions, Evolutionary Computing methods are utilised in order to optimise specific trading execution points within a trend and improve the potential profitability of trading returns. Although the approach may well be of value for general energy commodity futures trading (and indeed the wider financial and commodity derivative markets), this paper presents the application of an investment indicator for EUA carbon futures risk modelling and investment trend analysis only.
Highlights
For some time there has been an argument that the distributions of financial asset returns are non-Gaussian [3,4]
In order to develop a metric that is predictive of the future behaviour of carbon price, we consider the hypothesis that a change in the polarity of the Lyapunov-to-Volatility Ratio (LVR) indicates a pending change in a financial signal
In 2015, Sanin [14] modelled returns and volatility dynamics on the EU Emissions Trading Schemes (ETS) and demonstrated that a standard GARCH framework was inadequate for modelling carbon behaviour and that the assumption of Gaussian distributed data should be rejected due to the number of outliers
Summary
Signatories to the Paris Accord have ratified the intent to use carbon commodities as the key financial incentive mechanism to limit further climate change. The extent of change needed is such, that environmental and carbon commodity markets could yet become some of the most important traded commodities in the world It is positive (and necessary) to see an emerging trend in recent economic and policy research, whereby the impact of failing to sufficiently reduce carbon intensity levels is being shown to prove much more costly (for nations, regions, cities, and individuals alike) than the ‘do nothing’ scenario. This is the first clear warning signal for banks, hedge funds, pensions and private investors to actively seek out investments with an ‘environmental view’, and, on such a scale as to facilitate the level of change necessary. As a result of its history, it provides the most extensive data set from which to backtest any proposed hypothesis
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