Structural breaks, macroeconomic fundamentals and cross hedge ratio

Abstract

This paper proposes a new specification to estimate and evaluate the optimal hedge ratio. Due to the concern of structural breaks, we consider a time-varying transition probability regime switching model, which transition probability is driven by lower frequency macroeconomic fundamental variable, namely global policy uncertainty index. Based on the measure of variance reduction and expected utility gain, our model outperforms the specifications with fixed hedge ratio and OLS strategy with regime switching structural. Hence, it pays off to consider structural breaks and macroeconomic fundamental information. The excellent performance of the RS-TVTP-MIDAS model hinges on the ability to adjust strategies flexibly according to financial events.