Title: Crude oil hedging using a regime-switching model
Authors: Mahmoud Fatouh - Bank of England (United Kingdom)
Ioannis Moutzouris - City, University of London (United Kingdom)
Nikolaos Papapostolou - City University of London (United Kingdom)
Panos Pouliasis - City University of London (United Kingdom)
Anastasios Zalachoris - Bayes Business School (Greece) [presenting]
Abstract: A regime-switching model is proposed for determining the optimal hedge ratio in the Brent crude oil market. The suggested framework extends the constant optimal hedge ratio model, employing four different crude oil market states, defined according to certain financial and economic metrics. To measure its performance, the model is evaluated against four standard strategies (the nave 1:1 approach; the constant optimal hedge ratio; a time-varying optimal hedge ratio; and a 2-state Markov regime-switching model), in terms of variance reduction against the unhedged position benchmark. Our findings suggest that the proposed model outperforms the remaining hedging techniques by 36-51\%, while it reduces the unhedged position's variance by 95\%. Finally, the economic and policy-making implications of those findings are discussed.