Optimal Hedging in Carbon Emission Markets Using Markov Regime Switching Models

Abstract

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.