Proceedings of International Conference on Management, Economics and Finance
Optimal Cross Futures Hedging Under Regime Switching Time-Varying Correlated Jump Dynamic
A bivariate regime switching time-varying correlated jump model (RSTVCJ) is proposed for optimal hedging. Most of the existing discrete time hedging models does not consider simultaneously the jump risk and regime switching risk. Two recent articles (Lee 2009a, 2015) suggest jump switching models that possess both of these risks. These models, however, assume a common jump for spot and futures returns. This might be too restrictive because spot and futures returns are normally not perfectly correlated especially for the cases of cross hedging where the corresponding futures contract is not available for the underlying spot. In this paper, I release this common jump assumption and envision a regime switching time-varying correlated jump model for optimal hedging. In the proposed RSTVCJ, the spot and futures returns possess both self-owned and correlated jumps and the correlated jump is captured via a regime switching spillover factor. We illustrate the usefulness of RSTVCJ by performing the exercise of hedging jet fuel spot holding with crude oil futures. We compare the performance of RSTVCJ with its nested models including common jump (CJ), state-independent correlated jump (SICJ), regime switching correlated jump (RSCJ). Empirical results show that RSCJ has the best out-of-sample hedging performance. Regime switching correlated jump is superior to its state-independent or common jump counterparts. Adding time-varying dynamic to the jump process, however, does not further improve the hedging effectiveness.
Keywords: Regime switching; correlated time-varying jump; cross hedging.