Abstract
The article applies a Regime Switching Fractionally Integrated Error Correction Generalized Orthogonal (RSFIEC-GO) Generalized Autoregressive Conditional Heteroscedasticity (GARCH) model for optimal futures hedging. RSFIEC-GO captures both the relationships of fractional cointegration and regime shifts between spot and futures returns. Empirical investigation in agricultural commodity markets reveals that RSFIEC-GO provides superior hedging effectiveness compared to its nested models in terms of variance reductions. Results of Diebold, Mariano and West (DMW) test with adjusted McCracken's critical values also show the statistical superiority of RSFIEC-GO. This illustrates the importance of simultaneously modelling the fractional cointegration and regime shifts for dynamic futures hedging.
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