A bivariate Markov regime switching GARCH approach to estimate time varying minimum variance hedge ratios

Hsiang‐Tai Lee · Jonathan Yoder

94 citations0/0 files storedApplied Economics

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Financial Risk and Volatility Modeling Stochastic processes and financial applications Market Dynamics and Volatility

Abstract

This article develops a new bivariate Markov regime switching BEKK-Generalized Autoregressive Conditional Heteroscedasticity (GARCH) (RS-BEKK-GARCH) model. The model is a state-dependent bivariate BEKK-GARCH model and an extension of Gray's univariate generalized regime-switching (GRS) model to the bivariate case. To solve the path-dependency problem inherent in the bivariate regime switching BEKK-GARCH model, we propose a recombining method for the covariance term in the conditional variance-covariance matrix. The model is applied to estimate time-varying minimum variance hedge ratios for corn and nickel spot and futures prices. Out-of-sample point estimates of hedging portfolio variance show that compared to the state-independent BEKK-GARCH model, the RS-BEKK-GARCH model improves out-of-sample hedging effectiveness for both corn and nickel data. We perform White's (2000) data-snooping reality check to test for predictive superiority of RS-BEKK-GARCH over the benchmark model and find that the difference in variance reduction between BEKK-GARCH and RS-BEKK-GARCH is not statistically significant for either data set at conventional confidence levels.

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References

1986Generalized autoregressive conditional heteroskedasticity 1982Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation 1989A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle 1995Multivariate Simultaneous Generalized ARCH 1990Modelling the Coherence in Short-Run Nominal Exchange Rates: A Multivariate Generalized Arch Model 1994Autoregressive conditional heteroskedasticity and changes in regime 1979The Hedging Performance of the New Futures Markets 1993Time-Varying Distributions and Dynamic Hedging with Foreign Currency Futures

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