Dynamic Hedging using a Bivariate Markov Switching FIGARCH model

This paper develops a bivariate Markov Switching FIGARCH (MS-FIGARCH) process with constant and time varying transition probabilities as a way of modeling spot futures dynamics. An application of the model illustrates that the S&P500 and its futures exhibit long memory in volatility and structural breaks that are driven by changes in the cost of carry. The model with constant transition probabilities provides a slight improvement in hedging performance relative to an approach that does not allow for regime switching. On allowing the transition probabilities to be a function of the risk free rate, regime shifts are more effectively identified and improvements in hedging outcomes around the time of a break may be achieved. Email: [email protected]. I thank Bruce Grundy and Paul Kofman for their comments and helpful suggestions.