Hedging with CO2 allowances: the ECX market

We investigate and empirically estimate optimal hedge ratios, for the first time, in the EU ETS carbon market. Minimum variance hedge ratios are conditionally estimated with multivariate GARCH models, and unconditionally by OLS and the naïve strategy for the European Climate Exchange (ECX) market in the period 2005-2009. Also, utility gains are considered in order to take into account risk-return considerations. Empirical results indicate that dynamic hedging provides superior gains (in reducing the variance portfolio) compared to those obtained from static hedging, when adjustment costs are not taken into account. Moreover, results improve when the leptokurtic characteristics of the data are into consideration through distributions. Results are always compared in and out of sample, suggesting also that utility gains increase with investor's increased preference over risk.