Forecasting the volatility of EUA futures with economic policy uncertainty using the GARCH-MIDAS model

Jian Liu,Lizhao Yan,Fenghua Wen,Ziting Zhang

doi:10.1186/s40854-021-00292-8

Abstract

This study investigates the impact of economic policy uncertainty (EPU) on the volatility of European Union (EU) carbon futures prices and whether it has predictive power for the volatility of carbon futures prices. The GARCH-MIDAS model is applied for evaluating the impact of different EPU indexes on the price volatility of European Union Allowance (EUA) futures. We then compare the predictive power for the volatility of the two GARCH-MIDAS models based on different EPU indexes and six GARCH-type models. Our empirical results show that the GARCH-MIDAS models, which exhibit superior out-of-sample predictive ability, outperform GARCH-type models. The results also indicate that EPU has noticeable effect on the volatility of EUA futures. Specifically, the forecast accuracy of the EU EPU index is significantly higher than that of the global EPU index. Robustness checks further confirm that the EPU index (especially the EPU index of the EU) has strong predictive power for EUA futures prices. Additionally, using the volatility forecasting methods that GARCH-MIDAS models combine with the EPU index, investors can construct their portfolios to realize economic returns.

Highlights

Since the inception of the European Union Emissions Trading System (EU EU emission trading scheme (ETS)), carbon derivatives have been traded
GARCH‐MIDAS model To explore the contribution of a monthly frequency economic policy uncertainty (EPU) index to the long-term volatility of daily frequency European Union Allowance (EUA) futures, we adopt the GARCH-MIDAS model proposed by Engle et al (2013)
The results indicate that when EPU increases, the EU carbon market will become more volatile

Summary

Introduction

Since the inception of the European Union Emissions Trading System (EU ETS), carbon derivatives have been traded. The empirical results confirm that the EPU has great predictive performance for the volatility of EUA futures and that GARCH-MIDAS models significantly outperform GARCH-type models in forecasting performance by using the out-of-sample test. We use the GARCH-MIDAS model combined with EPU to analyze and predict fluctuations in EUA futures prices.

Results

Conclusion