Carbon Futures – Emerging Asset with Hedging Benefits

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Diversification is one way of minimizing the risk of a portfolio. A well-diversified portfolio contains numerous assets from various sectors, each having a small weight so that a crash of any individual security does not hit the entire portfolio. The authors behind this paper came up with a new idea for diversifying stock portfolios. They examined new emerging asset, carbon futures.

Because global warming is a severe problem, many central authorities have started to allocate a limited number of carbon permits, thus forcing carbon releasing firms to convert to greener practices. Many companies buy carbon allowances to satisfy their legal obligations. On the other hand, there are also companies which sell their carbon allowances. Therefore, the space for trading carbon futures emerged.

The authors calculate time-varying optimal hedge ratios and optimal weights for carbon futures. The primary outcome indicates that including a small amount of carbon futures in a stock portfolio delivers hedging benefits and reduces the overall risk for an expected return level. However, the hedge ratios are time-sensitive and highly dependent on the state of the market.

Additionally, the researchers  also analyzed the COVID-19 pandemic period and found that as hedging became more expensive and highly demanded, the benefits of the studied strategy deteriorated. The paper also compares the hedging effectiveness and diversification benefits of carbon futures with other common hedges. The results indicate that carbon futures are a better option than energy futures. However, the precious metals and agriculture futures show better diversification benefits.

Authors: Sercan Demiralay, Gaye Hatice Gencer, Selcuk Bayraci

Title: Carbon Credit Futures as an Emerging Asset Hedging, Diversification and Downside Risks

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4014292

Abstract:

Even though carbon futures as a new asset have attracted the attention of scholars, there have been few attempts to investigate potential benefits of investing in carbon credits. In this study, we analyse the feasibility of hedging and diversifying stocks with carbon futures. We adopt the dynamic conditional correlation (DCC) models which allows us to compute time-varying optimal hedge ratios, optimal weights and portfolio returns. These hedging and portfolio metrics are then compared with those derived for commodity futures. Our main results suggest that including a small portion of carbon futures in a stock portfolio provides hedging benefits and reduce overall risk for a given level of expected return, even though the hedge ratios are time-varying and significantly dependent on the market state. The COVID-19 outbreak has certainly changed the dynamics; as hedging becomes more expensive and the hedging effectiveness, measured by downside risk and symmetric variance reductions, is weakened, suggesting that the hedging capability of carbon futures is impaired during the pandemic. In terms of diversification benefits, our results show that including carbon in a stock portfolio improves the risk adjusted performance of stocks overall; however, these benefits deteriorate in the wake of the COVID-19. We further examine economic benefits as a measure of hedging performance and find evidence of positive utility gains that are strongly dependent on investors’ risk aversion and diminish after the pandemic. Comparing the performance of carbon futures with commodities, hedging effectiveness of carbon futures is not as high as that of precious metals and agriculture futures, however, carbon credits perform better than energy futures in terms of hedging and diversification.

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