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A Bivariate Markov Regime Switching GARCH Approach to Estimate Time Varying Minimum Variance Hedge Ratios

Author

Listed:
  • Hsiang-Tai Lee

    (Washington State University)

  • Jonathan Yoder

    (Washington State University)

Abstract

This paper develops a new bivariate Markov regime switching BEKK-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.

Suggested Citation

  • Hsiang-Tai Lee & Jonathan Yoder, 2005. "A Bivariate Markov Regime Switching GARCH Approach to Estimate Time Varying Minimum Variance Hedge Ratios," Econometrics 0506009, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpem:0506009
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    References listed on IDEAS

    as
    1. Engle, Robert F. & Kroner, Kenneth F., 1995. "Multivariate Simultaneous Generalized ARCH," Econometric Theory, Cambridge University Press, vol. 11(1), pages 122-150, February.
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    More about this item

    Keywords

    bivariate GARCH; require switching; hedging;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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