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A Markov regime‐switching ARMA approach for hedging stock indices

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  • Chao‐Chun Chen
  • Wen‐Jen Tsay

Abstract

This study considers the hedging effectiveness of applying the N‐state Markov regime‐switching autoregressive moving‐average (MRS‐ARMA) model to the S&P‐500 and FTSE‐100 markets. The distinguishingfeature of this study is to incorporate the observations of serially correlated stockreturns into the hedging analysis. To resolve the problem of N-super-T possible routes induced by the presence of MA parameters associated with the algorithm of Hamilton JD ( 1989 ) and a sample of size T, we propose an algorithm by combining the ideas of Hamilton JD ( 1989 ) and Gray SF ( 1996 ). We find that the hedging performances of the three proposed MRS‐MA(1) strategies herein are superior to their corresponding MRS counterparts considered in Alizadeh A and Nomikos N ( 2004 ) over the out‐of‐sample periods, even when we realistically track the transaction costs generated from rebalancing the hedged portfolios. © 2010 Wiley Periodicals, Inc. Jrl Fut Mark 31:165–191, 2011

Suggested Citation

  • Chao‐Chun Chen & Wen‐Jen Tsay, 2011. "A Markov regime‐switching ARMA approach for hedging stock indices," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 31(2), pages 165-191, February.
    • Handle: RePEc:wly:jfutmk:v:31:y:2011:i:2:p:165-191
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    Cited by:

    1. Zhipeng, Yan & Shenghong, Li, 2018. "Hedge ratio on Markov regime-switching diagonal Bekk–Garch model," Finance Research Letters, Elsevier, vol. 24(C), pages 49-55.
    2. Yu, Xing & Li, Yanyan & Lu, Junli & Shen, Xilin, 2023. "Futures hedging in crude oil markets: A trade-off between risk and return," Resources Policy, Elsevier, vol. 80(C).
    3. Park, Jin Suk & Shi, Yukun, 2017. "Hedging and speculative pressures and the transition of the spot-futures relationship in energy and metal markets," International Review of Financial Analysis, Elsevier, vol. 54(C), pages 176-191.
    4. Chang, Kuang-Liang, 2016. "Does the return-state-varying relationship between risk and return matter in modeling the time series process of stock return?," International Review of Economics & Finance, Elsevier, vol. 42(C), pages 72-87.
    5. Kim, Myeong Jun & Park, Sung Y., 2016. "Optimal conditional hedge ratio: A simple shrinkage estimation approach," Journal of Empirical Finance, Elsevier, vol. 38(PA), pages 139-156.
    6. Geir D. Berentsen & Jan Bulla & Antonello Maruotti & Bård Støve, 2022. "Modelling clusters of corporate defaults: Regime‐switching models significantly reduce the contagion source," Journal of the Royal Statistical Society Series C, Royal Statistical Society, vol. 71(3), pages 698-722, June.

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