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

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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.

Document Type: Research Article

DOI: http://dx.doi.org/10.1080/00036840500438970

Affiliations: 1: Department of Banking and Finance, National Chi Nan University, Taiwan 2: School of Economic Sciences, Washington State University, USA

Publication date: June 1, 2007

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