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Optimal quantile hedging under Markov regime switching

Author

Listed:
  • Donald Lien

    (The University of Texas at San Antonio)

  • Ziling Wang

    (South China University of Technology)

  • Xiaojian Yu

    (South China University of Technology
    South China University of Technology)

Abstract

In this study, we introduce a new quantile hedging method by extending the conventional quantile hedging with two-state Markov regime switching models. Using daily data from 16 futures markets, we discover that the conventional quantile hedge ratio displays an inverted U shape to various extents for different futures. When looking into high- and low-volatility states, quantile hedge ratios show different results compared with conventional models. While the quantile hedge ratio in low-volatility state is relatively flat, in high-volatility state, the quantile hedge varies with the spot return distribution and displays a U-type relationship. Moreover, the U shape is more prominent for agricultural futures and less prominent for others. Also, by comparing hedging effectiveness, the quantile hedge strategy is found to be more effective than the no-hedge strategy and the hedging strategy derived from error correction models.

Suggested Citation

  • Donald Lien & Ziling Wang & Xiaojian Yu, 2021. "Optimal quantile hedging under Markov regime switching," Empirical Economics, Springer, vol. 60(5), pages 2177-2201, May.
    • Handle: RePEc:spr:empeco:v:60:y:2021:i:5:d:10.1007_s00181-020-01831-5
    DOI: 10.1007/s00181-020-01831-5
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    More about this item

    Keywords

    Futures; Quantile hedging; Markov regime switching; Hedge ratio;
    All these keywords.

    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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