IEEE TRANSACTIONS ON AUTOMATION SCIENCE AND ENGINEERING
Variance Minimization Hedging Analysis Based on
a Time-Varying Markovian DCC-GARCH Model
Jia Wang , MengChu Zhou , Fellow, IEEE, Xiu Jin, Xiwang Guo , Liang Qi , Member, IEEE, and Xu Wang
Abstract— Considering time-varying transition probability
(TVTP), this article combines Markov regime switching with
a dynamic conditional correlation generalized autoregressive
conditional heteroscedasticity (DCC-GARCH) model to construct
a new hedging model and study a state-dependent minimum
variance hedging ratio. A two-stage maximum likelihood method
is constructed to estimate the model parameters. A filtering
algorithm is used in an estimation process. Empirical results
on commodity futures hedging show that compared with other
benchmark models, the proposed one has the best fitting effect.
In addition, in terms of hedging effectiveness, the proposed model
is superior to other models in most cases, which means that
introducing TVTP into a DCC-GARCH model can effectively
improve the performance of hedging portfolio.
Note to Practitioners—This article deals with a state-dependent
minimum variance hedging problem. It combines a time-varying
Markov regime switching with dynamic conditional correlation
generalized autoregressive conditional heteroscedasticity named
Manuscript received July 14, 2019; accepted August 24, 2019. This article
was recommended for publication by Associate Editor K.-H. Chang and
Editor Y. Ding upon evaluation of the reviewers’ comments. This work was
supported in part by NSFC under Grant 71601040, in part by the Fundamen-
tal Research Funds for the Central Universities under Grant N172304020,
in part by the Hebei Province Natural Science Foundation under Grant
G2019501086, in part by the China Postdoctoral Science Foundation under
Grant 2018M631797, in part by the 2019 Annual Social Science Foundation of
Hebei Institutions of Higher Education under Grant SQ191015, in part by the
Hebei Association Social Science and Technology Foundation under Grant
2019041201004, in part by the Liaoning Province Education Department
Scientific Research Foundation of China under Grant L2019027, and in part
by the Liaoning Province Dr. Research Foundation of China under Grant
20170520135 (Corresponding author: MengChu Zhou.)
J. Wang is with the School of Economics, Northeastern University at
Qinhuangdao, Qinhuangdao 066004, China, and also with the School of
Business Administration, Northeastern University, Shenyang 110819, China
(e-mail: wangjia@neuq.edu.cn).
M. Zhou is with the Department of Electrical and Computer Engineering,
New Jersey Institute of Technology, Newark, NJ 07102 USA, and also
with the Institute of Systems Engineering, Macau University of Science and
Technology, Macau 999078, China (e-mail: zhou@njit.edu).
X. Jin is with the School of Business Administration, Northeastern Univer-
sity, Shenyang 110819, China (e-mail: xjin@mail.neu.edu.cn).
X. Guo is with the College of Computer and Communication Engineer-
ing, Liaoning Shihua University, Fushun 113001, China, and also with the
Department of Electrical and Computer Engineering, New Jersey Institute of
Technology, Newark, NJ 07102 USA (e-mail: x.w.guo@163.com).
L. Qi is with the Department of Computer Science and Technology,
Shandong University of Science and Technology, Qingdao 266590, China
(e-mail: qiliangsdkd@163.com).
X. Wang is with the College of Economics, Hebei University
of Environmental Engineering, Qinhuangdao 066102, China (e-mail:
45065706@qq.com).
This article has supplementary downloadable material available at
http://ieeexplore.ieee.org, provided by the authors.
Color versions of one or more of the figures in this article are available
online at http://ieeexplore.ieee.org.
Digital Object Identifier 10.1109/TASE.2019.2938673
1545-5955 © 2019 IEEE. Personal use is permitted, but republication/redistribution requires IEEE permission.
See http://www.ieee.org/publications_standards/publications/rights/index.html for more information.
1
DCC-GARCH to construct a new hedging model and esti-
mates a state-dependent hedging ratio. Empirical results from
commodity futures hedging show that introducing TVTP into
the DCC-GARCH model can effectively reduce portfolio risk
and provide better hedging performance than other traditional
models, including Markov regime switching DCC-GARCH with
a fixed transition probability, DCC-GARCH, ordinary least
squares, naïve hedging strategies, and unhedged spots. Thus,
this article is of guiding significance for hedgers to fully learn
the hedging rules of futures market and avoid the spots price
risk.
Index Terms— Big data, hedging, Markov regime switching
(MRS), time series, time-varying transition probability (TVTP).
I. I NTRODUCTION
A S AN essential part of financial markets, futures market
mainly realizes risk transfer by hedging. The main prob-
lem of hedging theory is to determine the optimal hedging
ratio. Traditional naïve hedging strategies usually adopt a
1:1 ratio, which means that the number of the futures contract
and spots holdings is equal. Because of basis risk [1], such
ratio is not optimal. Under a mean-variance framework, Eder-
ington for the first time proposes a minimum variance hedging
strategy. It is obtained by an ordinary least squares (OLS)
method, which overcomes the deficiency of the naïve hedging
method [2]. However, OLS neglects volatility clustering, and
the minimum variance hedging ratio is thus static. The optimal
hedging ratio should be time varying with the fluctuation
of spots and futures prices [3]. A generalized autoregressive
conditional heteroscedasticity (GARCH) model is usually used
to describe the time varying fluctuation of risky assets in
financial markets [4], [5], and the dynamic optimal hedging
strategy based on GARCH is more realistic [6], [7]. Since
then, GARCH models have been widely used in hedging
research. Chang et al. [8] use eight hedging models includ-
ing matrix-diagonal GARCH, constant conditional correlation
GARCH, and other traditional models to investigate hedging
effectiveness in energy futures markets. They find that hedging
effectiveness is higher in bull markets than that in bear
markets. Zhou [9] uses a dynamic conditional correlation
GARCH (DCC-GARCH) to study hedging between Standard
& Poor Global REIT Index and REIT index futures. It is
proved that the hedging ratio estimated by DCC-GARCH
model is more accurate than that by GARCH with a constant
correlation coefficient. Basher and Sadorsky [10] use DCC,
asymmetric DCC, and generalized orthogonal GARCH to
study the hedging strategy among emerging market stock
2 IEEE TRANSACTIONS ON AUTOMATION SCIENCE AND ENGINEERING
prices, oil prices, VIX, gold prices, and bond prices [10]. The
results show that hedging ratios from the asymmetric DCC
model are the most effective for hedging emerging market
stock prices with oil, VIX, or bonds. Hedging ratios estimated
by the generalized orthogonal GARCH are the most effective
for hedging stock prices with gold.
Many scholars point out that GARCH models have a
defect, i.e., the volatility term in GARCH is highly persistent,
and historical volatility, has persistent impact on current and
future volatility. Thus, they cannot accurately depict too large
or too small fluctuations of asset prices according to [11].
A Markov regime switching mechanism is always explored
in regime identification and regime prediction [12]–[15]. And
some studies have applied a Markov model to describe the
dynamic financial markets. For example, Zhang and Li [16]
construct a Markov model to analyze options and hedging in
European financial derivative markets. Tenyakov et al. [17] use
a Markov model to describe financial market liquidity regimes.
Thus, considering the dependence of volatility on regime,
a Markov model is introduced to model them and a Markov
regime switching GARCH model is constructed [18]. Many
studies explore the effect of regime switching on improving
the accuracy of hedging ratios and hedging performance
from both theoretical and empirical aspects. Markopoulou and
Skintzi [19] combine ARMA where ARMA stands for autore-
gressive moving average model, ARMA-GARCH, Markov,
and heterogeneous autoregressive models to study the realized
minimum variance hedging ratio of equity indices and foreign
exchange rates. Su [20] analyzes the risk hedge between
the Morgan Stanley Taiwan stock index and its underlying
futures by using trend- and volatility-involved regime switch-
ing models. It concluded that such models perform well in
terms of wealth increase. Yan and Li [21] use a Markov
regime switching multivariate GARCH model to estimate the
hedging ratio of CSI300 index futures. They conclude that
the model can derive the optimal hedging strategy. In Markov
regime switching DCC, only DCC parameters are driven by a
Markov chain [22]. Philip and Shi [23] construct a modified
Markov regime switching DCC-GARCH model such that the
parameters of DCC and GARCH are all driven by a Markov
chain. They study the optimal hedging strategy in carbon
emission markets of European Union and find that all regime
switching-based hedging strategies significantly outperform a
single regime hedging strategy. Billio et al. [24] develop a
Bayesian multi-chain Markov switching GARCH model to
define a robust minimum variance hedging strategy in energy
futures markets.
Most studies on the hedging of futures assume that the
transition probability remains constant when constructing a
Markov regime switching model. In uncertain financial mar-
kets, Filardo [25] considers a time-varying transition proba-
bility (TVTP). Then, other scholars study a Markov regime
switching model with TVTP and state that compared with
fixed transition probability, TVTP has more freedom, and can
improve the predictive ability of a Markov model [26], [27].
Can we build a hedging model based on a Markov model
with TVTP to find the optimal hedging ratio and hedging
performance in the futures market? How much gain can we
obtain at what computational price?
By trying to answer the above questions, this article aims
to make three contributions to the estimation of the minimum
variance hedging ratio. First, by considering time-varying
Markov regime transition probability, based on the tradi-
tional DCC-GARCH, we present a Markov regime switching
DCC-GARCH model with TVTP (DCC-GARCH+ ) to esti-
mate the minimum variance hedge ratio. Second, we produce
one-step-ahead forecasts in out-of-sample period and compare
the results of our approach with some benchmark models,
including a Markov regime switching DCC-GARCH model
with fixed transition probability (DCC-GARCH0 ) [22], DCC-
GARCH, OLS, naïve hedging strategy, and unhedged spots.
These benchmark models contain almost all the hedging mod-
els that scholars have proposed. Third, the hedging portfolios
are constructed from four pairs of commodity spots and
futures, including gold, silver, copper, and aluminum. The
empirical results are more robust than that by considering only
one pair of commodity assets.
The rest of this article is organized as follows. In Section II,
we construct a Markov regime switching DCC-GARCH model
with TVTP and give an estimation approach. In Section III,
a method of estimating hedging ratios and measuring hedging
effectiveness are introduced. In Section IV, we discuss the
results of parameter estimation and derive hedging ratios
in-and out-of-samples. Then, the hedging performances of dif-
ferent models are compared. Section V concludes this article.
II. M ODEL S PECIFICATION
A. Markov DCC-GARCH Model With TVTP
By adopting the main idea of Markov DCC-GARCH in
[23], which is similar to a DCC-GARCH0 , we construct a
Markov regime switching DCC-GARCH model with a TVTP
(called DCC-GARCH+ for short) as follows:
r t = μst + εt,st , εt,st |t −1 ∼ N(0, H t,st ) (1)
where rt = (rc,t , r f,t ) is a return vector of spot and futures and
μst = (μc,st , μ f,st ) is a vector of conditional mean returns.
The residual term εst ,t = (Ec,t,st , E f,t,st ) is assumed to be
normally distributed with a mean 0 and a covariance matrix
H t,st . t −1 is a set of information available at time t− 1.
st = {1, 2} is an unobservable state variable and is assumed
to follow a two-state first-order Markov chain. The transition
probability of the current state is a function of the observable
information in the past time, and the transition probability is
time-varying [26]. To ensure the estimated probability within
(0, 1), we use the following logistic functions:
1
p12,t = (2)
1 + exp(a1 + b1 z t −1 )
1
p21,t = (3)
1 + exp(a2 + b2 z t −1 )
where p21,t is the probability with which state 1 at time
t + 1 is followed by state 2 at time t. a1 , b1 , a2 , and b2
are unconstrained constant terms that are estimated along
WANG et al.: VARIANCE MINIMIZATION HEDGING ANALYSIS 3

with other unknown parameters through maximum likelihood covariance and correlation coefficients
estimation. z t −1 is the available information at time t− 1.
Viswanath [28] states that the basis between spot and futures h c f,t = E(rc,t r f,t |
t −1) − E(rc,t |
t −1 )E(r f,t |
t −1 )
prices is able to provide some information about price trend = θ1,t [μc,1 μ f,1 + h c f,t,1 ] + θ2,t [μc,2 μ f,2 + h c f,t,2 ]
in the future and have some effect on regime switching. −(θ1,t μc,1 + θ2,t μc,2 )(θ1,t μ f,1 + θ2,t μ f,2 ) (12)
Here, the transition probability is regarded as a function 1
of the lagged form of spot–futures basis. Let z t −1 be the ρc f,t = {[θ1,t (μc,1 μ f,1 +ρc f,t,1h c,t,1 h f,t,1 )
h c,t h f,t
spot–futures basis at time t − 1.
+θ2,t (μc,2 μ f,2 +ρc f,t,2 h c,t,2 h f,t,2 )]
The conditional variances of spot and futures return are
modeled as a GARCH(1, 1) process in [29]. h 2c,t,st and − [θ1,t μc,1 +θ2,t μc,2 ][θ1,t μ f,1 +θ2,t μ f,2 ]}.
h 2f,t,st are state-dependent conditional variances at time t for (13)
spot and futures, respectively. h c f,t,st is a state-dependent
conditional covariance between spot and futures at time In (1)–(13), all unknown parameters of DCC-GARCH+ can
t.ρc f,t,st is a state-dependent dynamic conditional correlation be combined to a parameter vector
coefficient between spot and futures at time t. The time-  
μc,st , μ f,st , γc,st , αc,st , βc,st , γ f,st , α f,st ,
varying, state-dependent, and definite covariance matrix H t,st = .
β f,st , θ1,st , θ2,st , a1 , b1 , a2 , b2 , ρ
is formalized as
 2  In this article, a two-stage maximum likelihood method is used
h c,t,st h c f,t,st to estimate .
H t,st =
h c f,t,st h 2f,t,st
   
h c,t,st 0 1 ρc f,t,st h c,t,st 0
= . B. Estimation Procedure of DCC-GARCH+
0 h f,t,st ρc f,t,st 1 0 h f,t,st
(4) The estimation of DCC-GARCH+ is performed via a two-
stage maximum likelihood estimation with the following like-
We assume that the volatility dynamics follow a regime lihood function:
switching GARCH (1, 1) process given by:
T
L() = log f (εt |t −1 ) (14)
h 2c,t,st = γc,st + αc,st εc,t
2
−1 + βc,st h c,t −1,st
2
(5) t =1
h 2f,t,st = γ f,st + α f,st ε2f,t −1 + β f,st h 2f,t −1,st (6) where T denotes the total number of observations and
ρc f,t,st = (1 − θ1,st −θ2,st )ρ +θ1,st ηt 1 ηt 1 +θ2,st ρc f,t −1 (7) f (ε t |t −1 ) is the probability density function of εt , with
conditional state probability as its weight.
where θ1,st and θ2,st are DCC parameters, ρ is an uncondi- The detailed steps for estimation are as follows.
tional correlation coefficient between spot and futures, η t = 1) Conditional variances h 2c,t,st and h 2f,t,st of spot and
[ηc,t , η f,t ] is a vector of unconditional standardized residuals, futures returns are estimated, respectively, by using
ηi,t = εi,t /h i,t , and εi,t and h i,t are unconditional residual a time-varying Markov regime switching GARCH
and standard deviation, respectively, with i ∈{c, f }. When a (1, 1) model.
GARCH process is subject to regime switching, the recursive 2) Given h 2c,t,st and h 2f,t,st , the model parameters
nature of the process makes the model intractable due to the are estimated by using the Hamilton’s filtering
dependence of conditional variance on entire historical data algorithm [33]. The detailed processes are as follows.
[30], [31]. To solve this path-dependency problem, we apply a) Given a filtered probability P(st −1 |t −1 ), project
the recombining method in [30]. The conditional residuals and the conditional state probabilities
variances are recombined into the unconditional variables by
using the following equations:
2
P(st |t −1 ) = P(st , st −1 |t −1 )
εc,t = rc,t − E[rc,t |t−1 ] = rc,t −[θ1,t μc,1 +θ2,t μc,2 ] (8) st−1 =1

ε f,t = r f,t − E[r f,t |t −1 ] = r f,t −[θ1,t μ f,1 +θ2,t μ f,2 ] (9)
2
 2    = P(st |st −1 )P(st −1 |t −1 ) (15)
h 2c,t = E rc,t |
t−1 − E(rc,t |
t−1 )2 = θ1,t μ2c,1 +h 2c,t,1
  st−1 =1
+θ2,t μ2c,2 +h 2c,t,2 −(θ1,t μc,1 +θ2,t μc,2 )2 (10)
 2    2  where the initial filtered probabilities are θ10 =
2 
h f,t = E r f,t |
t−1 − E(r f,t
t −1 ) = θ1,t μ f,1 +h f,t,1
2 2
  P(s0 = 1|0 ) = 0.5 and θ20 = P(s0 = 2|0 )
+θ2,t μ2f,2 +h 2f,t,2 −(θ1,t μ f,1 +θ2,t μ f,2 )2 (11) = 0.5 [34].
b) Construct the regime-dependent conditional den-
where a conditional state probability θst ,t = P(st |t −1 ) sity function as the following likelihood function:
represents the probability of being in state st at time t given
observations from time 0 to t− 1, where st ∈{1, 2}. f (εt |st , t −1 )
 
According to [30], Lee and Yoder [32] present an approach 1 1  −1
= exp − εt,st Ht,st εt,st . (16)
to solve the path-dependency problem with conditional 2θ|Ht,st |1/2 2
4 IEEE TRANSACTIONS ON AUTOMATION SCIENCE AND ENGINEERING

c) Based on P(st |t −1 ) and f (εt |st , t −1 ), construct As the value of VR is close to 1, the risk of a hedging
the mixed likelihood portfolio gets smaller compared to that of the spot, which

2 means that the hedging strategy is more effective.
f (εt |t −1 ) = P(st |t −1 ) f (ε t |st , t −1 ). (17) The second one is an EU. According to [20], the mean-
st =1 variance EU function is constructed as
d) Update the filtered probabilities 1
E[U (r p,t )|t −1 ] = E[r p,t |t −1 ] − λVar[r p,t |t −1 ] (24)
2
P(st |εt , t −1 )
where E[r pt |t −1 ] is the expected return of a hedging port-
P(st |t −1 ) f (εt |st , t −1 )
= P(st |t ) =
2 . folio and λ denotes the coefficient of absolute risk aversion
st =1 P(st |t −1 ) f (εt |st , t −1 ) and is set to be 4 [36]. A higher EU value indicates that
(18) the corresponding hedging portfolio provides more economic
benefit.
e) Calculate the weighted average volatilities and
The third one is a Sp, which is the excess return of a
correlation according to (10), (11), and (13).
portfolio under unit risk
f) Repeat a)–e) until the end of the sample and
obtain likelihood r p,t − rt0
⎛ ⎞ Sp =  (25)
T 2
Vt
Hg
L() = log ⎝ P(st |t −1 ) f (εt |st , t −1 )⎠.
t =1 st =1 where rt0 is a riskless interest rate meaning that investors can
(19) obtain it by investing their money in an asset with no risk. It is
regarded as a demand deposit rate. A higher sharp indicates
III. M INIMUM VARIANCE H EDGE R ATIO AND H EDGING that the excess return of a portfolio under unit risk is higher,
P ERFORMANCE M EASUREMENT implying a more effective hedging strategy.
The fourth one is VaR. VaR means the maximum possible
We suppose that an investor holds one unit of spot at
loss of a financial asset in a specific future period at a certain
time t. To avoid the risk derived from the fluctuations of
level of confidence. VaR of a hedging portfolio at a confidence
spot, bt units of futures are sold. The return of the portfolio is
level q is given by the smallest number l such that the
given by
probability that a loss of the hedging portfolio M exceeds l
r p,t = rc,t − bt · r f,t (20) is not larger than 1 −q. The VaR of a hedging portfolio at
confidence level q is
where rc,t and r f,t are, respectively, the returns of the spot
and futures at time t. VaRq = inf{l ∈ R : P(M > l) ≤ 1 − q} (26)
A minimum variance method is used to estimate the hedging
where l is the critical loss of the hedging portfolio. A smaller
ratio [35]. The smaller the variance of the portfolio return,
VaRq indicates that the critical loss l is smaller, signifying a
the better is the hedging strategy. The objective function is
more effective hedging strategy. A better hedging strategy can
min var(rc,t − bt · r f,t ) provide a lower VaR exposure. In our case, VaRq is calculated
= var(rc,t ) + bt2 var(r f,t ) − 2bt cov(rc,t , r f,t ). (21) by the sample quantiles by using the empirical distribution of
the hedging portfolio returns.
Then, the optimal hedging ratio with the minimum
variance is IV. E XPERIMENTAL R ESULTS AND A NALYSIS
cov(ct , ft ) h c,t
bt = = ρc f,t (22) A. Data Description
σ f,t
2 h f,t
In this section, DCC-GARCH+ is applied to commodity
where ρc f,t , h c,t , and h f,t are estimated through (10), (11), spots and futures of gold, silver, copper, and aluminum in
and (13), respectively. the period from January 2013 to August 2018. As we all
In order to analyze the hedging performance, we give four know, the strategic interactions among participants play a
metrics, including variance reduction (VR), expected utility critical role in market dynamics. The impact of compre-
(EU), sharp ratio (Sp), and value at risk (VaR). The first three hensive trading strategies of all the market participants is
metrics are derived from the variances of spots and futures. reflected in the closing prices of stocks. Therefore, the closing
The variance is usually used to describe financial risks that prices of the spots and futures are used as sample data
reflect the volatility range of the markets. The last metric VaR to study the hedging strategic interactions among market
is usually used to describe the risk of rare events. participants, which are reasonable. Spots and futures closing
The first one is VR prices are daily prices obtained from the Shanghai met-
Vt0 − Vt Vt als’ market (http://www.shmet.com/Home.html) and Shanghai
VR = 0
=1− 0 (23) futures exchange website (http://www.shfe.com.cn/), respec-
Vt Vt
tively. According to [35], the return of each commodity is
where Vt0 is the variance of the unhedged spot and Vt is the computed with ri,t ∈100 × (ln pi,t − ln pi,t −1 ), where pi,t is
variance of the hedging portfolio. the closing price of each commodity at time t with i = {c, f }.
8 IEEE TRANSACTIONS ON AUTOMATION SCIENCE AND ENGINEERING
Fig. 5. Out-of-sample optimal hedge ratios for gold.
Fig. 6. Out-of-sample optimal hedge ratios for silver.
Fig. 7. Out-of-sample optimal hedge ratios for copper.
Fig. 8. Out-of-sample optimal hedge ratios for aluminum.
3) The conditional variance and covariance at time T + 1
are recombined to obtain an unconditional variance
h 2c,T +1 , h 2f,T +1 , and unconditional covariance h c f,T +1 ,
respectively.
4) The hedging ratios are estimated according to (22).
Using the rolling window method to make one-step forward
prediction until the end of the out of sample. The prediction
processes of DCC-GARCH0 are similar to those of DCC-
GARCH+ .
For DCC-GARCH, the covariance and residual at time T
are used to estimate the covariance at time T + 1, and then
the hedging ratios at time T + 1 are calculated by using (22).
Figs. 5–8 show the prediction results for out-of-sample
hedging ratios regarding the four kinds of metals. The hedging
ratios estimated by DCC-GARCH are less volatile and has
a narrower range than those estimated from the other two
models for all the commodities. As shown in Fig. 2, the hedg-
ing ratios of gold futures estimated from DCC-GARCH+
and DCC-GARCH0 lie between −0.1536 and 1.3354 and
between −0.1072 and 1.3552, respectively, while the hedging
ratios estimated from DCC-GARCH is between −0.1483 and
1.0761. The volatilities of hedging ratios estimated from
three models equal 0.0668, 0.0241, and 0.0482, respectively.
Besides, Table IV gives the Wilcox pair-wise tests of out-
of-sample gold futures hedging ratios estimated from three
models. Additional results are given in Table A in the sup-
plement file. We can see that all the P values of the three
pairs approximately equal 0, and therefore the hedging ratios
of the Wilcox pair-wise tests are all statistically different.
Overall, DCC-GARCH+ is more flexible than the other two
models, and the result is different from that at in-sample
period, which means that the TVTP is good at describing
the real characteristic of dynamically updated information, and
from comparison DCC-GARCH+ seems to be more suitable
for an out-of-sample prediction studies.
D. Estimation of Hedging Performance
The in-sample and out-of-sample hedging performance of
the four pairs of spots and futures estimated by three models,
OLS, and naive hedging strategy (1:1) are compared, respec-
tively. The performance of the unhedged spots is also derived.
Tables V and VI give the in-sample and out-of-sample results
of hedging performance, including average VR, average EU,
average Sp, and VaRq (q = 95% and 90%).
6 IEEE TRANSACTIONS ON AUTOMATION SCIENCE AND ENGINEERING

TABLE III
E STIMATE OF U NKNOWN PARAMETERS OF T HREE M ODELS FOR F OUR C OMMODITIES

Fig. 1. In-sample optimal hedge ratios for gold.

Fig. 2. In-sample optimal hedge ratios for silver.

0.0734 and 0.6103 for spot and futures, respectively. Given α
and β, higher γ indicates higher steady-state volatility. α + β
measures the volatility persistence and is higher in state 1
than that in state 2. Taking copper for instance, α + β for
spot in state 1 and state 2, respectively, equals to 0.96 and
0.7984, and α + β for futures in states 1 and 2, respectively,
equals 0.9467 and 0.7072. Hence, compared with the low-
volatility state, volatility persistence tends to be higher in the
high-volatility state.
In general, from the analysis of the above parameters,
we can see that the two Markov DCC-GARCH models
are suitable for studying the hedging problem in Chinese
futures market. Besides, compared with Akaike information
criterion (AIC), Bayesian information criterion (BIC) is more
appropriate for large-size samples to test the fitting effect
of models. Therefore, BIC of the three models is derived
in Table III. We can see that the BIC of DCC-GARCH+ is the
smallest, and, therefore, this model is the best in comparison
with the other two models.
C. Estimation of Optimal Hedging Ratios
1) In-Sample Hedging Ratios: Figs. 1–4 show the in-sample
hedging ratios of DCC-GARCH+ , DCC-GARCH0 , and
WANG et al.: VARIANCE MINIMIZATION HEDGING ANALYSIS
Fig. 3. In-sample optimal hedge ratios for copper.
Fig. 4. In-sample optimal hedge ratios for aluminum.
TABLE IV
W ILCOX PAIR -W ISE T ESTS OF H EDGING R ATIOS E STIMATED BY T HREE M ODELS I N - AND O UT- OF -S AMPLE (G OLD )
DCC-GARCH for the pairs of spots and futures regarding
gold, silver, copper, and aluminum. Furthermore, we also
estimate the in-sample hedging ratios with the OLS method for
four pairs of assets, i.e., 0.7317, 0.9290, 0.6495, and 0.5861.
Taking gold for instance, as shown in Fig. 1, the hedging
ratios estimated from DCC-GARCH+ and DCC-GARCH0
lie between 0.1243 and 1.3301 and between 0.0329 and
1.8005, respectively, while the hedging ratios estimated
from DCC-GARCH is between 0.2599 and 1.0985. The
volatilities of hedging ratios estimated from DCC-GARCH+ ,
DCC-GARCH0 , and DCC-GARCH equal 0.0175, 0.0315, and
0.0091, respectively.
Besides, we use Wilcoxon pair-wise test to check whether
there is the same distribution between the hedging ratios esti-
mated from the three models. The method is a nonparametric
statistical hypothesis test. And it is used to compare two
related samples, matched samples, or repeated measurements
on a single sample by assessing whether they follow the
same distribution. The test includes a null hypothesis that
two samples follow the same distribution and an alternative
hypothesis that distribution of two samples is different. If the
P value is bigger than the significance level 0.05, then the
null hypothesis cannot be rejected and if the P value is less
than 0.05, then null hypothesis is rejected and alternative
hypothesis is accepted. If the null hypothesis is accepted then
both samples are equivalent to each other, while if alternative
hypothesis is accepted then both samples are not equivalent
to each other. Table IV gives the results of in-sample gold
futures. The results of three other metals are given in Table A
7
in the Supplement File. Notably, most of the P values are
less than 0.05, which demonstrates that the hedging ratios
estimated from the three models are significantly different
in the population distribution. Hence, we can compare the
hedging performance of the three models further.
Overall, we find that the hedging ratios estimated by
DCC-GARCH are less volatile and have a narrower range
for all the in-sample commodities, which means that
DCC-GARCH is less flexible than the other two Markov
DCC-GARCH models. Moreover, DCC-GARCH0 is more
flexible than DCC-GARCH+ , because there is no new infor-
mation added during this period, and, therefore, TVTP has less
effect on the flexibility of the model.
2) Out-of-Sample Hedging Ratios: With a rolling window
method [37], the hedging ratios of three GARCH models for
the four pairs of spots and futures are predicted, respectively.
When new information is received, the models are estimated
again, and new hedging ratios are obtained. Taking DCC-
GARCH+ , for instance, the detailed processes for prediction
are as follows.
1) Suppose that the sample size is T . The conditional state
probability θsT +1 ,T +1 (sT +1 = {1, 2}) at time T + 1
is estimated by using a conditional state probability
θsT ,T (sT = 1, 2) at time T , and the state transition
probability matrix is P.
2) With the conditional covariance matrix H T ,sT and resid-
ual ε T ,sT , for each state at time T , the conditional
covariance matrix H T +1,sT +1 under each state at time
T + 1 are estimated according to (4)–(7).
8 IEEE TRANSACTIONS ON AUTOMATION SCIENCE AND ENGINEERING
Fig. 5. Out-of-sample optimal hedge ratios for gold.
Fig. 6. Out-of-sample optimal hedge ratios for silver.
Fig. 7. Out-of-sample optimal hedge ratios for copper.
Fig. 8. Out-of-sample optimal hedge ratios for aluminum.
3) The conditional variance and covariance at time T + 1
are recombined to obtain an unconditional variance
h 2c,T +1 , h 2f,T +1 , and unconditional covariance h c f,T +1 ,
respectively.
4) The hedging ratios are estimated according to (22).
Using the rolling window method to make one-step forward
prediction until the end of the out of sample. The prediction
processes of DCC-GARCH0 are similar to those of DCC-
GARCH+ .
For DCC-GARCH, the covariance and residual at time T
are used to estimate the covariance at time T + 1, and then
the hedging ratios at time T + 1 are calculated by using (22).
Figs. 5–8 show the prediction results for out-of-sample
hedging ratios regarding the four kinds of metals. The hedging
ratios estimated by DCC-GARCH are less volatile and has
a narrower range than those estimated from the other two
models for all the commodities. As shown in Fig. 2, the hedg-
ing ratios of gold futures estimated from DCC-GARCH+
and DCC-GARCH0 lie between −0.1536 and 1.3354 and
between −0.1072 and 1.3552, respectively, while the hedging
ratios estimated from DCC-GARCH is between −0.1483 and
1.0761. The volatilities of hedging ratios estimated from
three models equal 0.0668, 0.0241, and 0.0482, respectively.
Besides, Table IV gives the Wilcox pair-wise tests of out-
of-sample gold futures hedging ratios estimated from three
models. Additional results are given in Table A in the sup-
plement file. We can see that all the P values of the three
pairs approximately equal 0, and therefore the hedging ratios
of the Wilcox pair-wise tests are all statistically different.
Overall, DCC-GARCH+ is more flexible than the other two
models, and the result is different from that at in-sample
period, which means that the TVTP is good at describing
the real characteristic of dynamically updated information, and
from comparison DCC-GARCH+ seems to be more suitable
for an out-of-sample prediction studies.
D. Estimation of Hedging Performance
The in-sample and out-of-sample hedging performance of
the four pairs of spots and futures estimated by three models,
OLS, and naive hedging strategy (1:1) are compared, respec-
tively. The performance of the unhedged spots is also derived.
Tables V and VI give the in-sample and out-of-sample results
of hedging performance, including average VR, average EU,
average Sp, and VaRq (q = 95% and 90%).
WANG et al.: VARIANCE MINIMIZATION HEDGING ANALYSIS 9

TABLE V
I N -S AMPLE H EDGING P ERFORMANCE

TABLE VI
O UT- OF -S AMPLE H EDGING P ERFORMANCE

1) In-Sample Hedging Performance: From Table V, we can
see that compared with DCC-GARCH0 , the values of VR,
EU, and Sp obtained by DCC-GARCH+ are higher. The
values of VaR95% and VaR90% obtained by DCC-GARCH+ are
smaller than that obtained by DCC-GARCH0 , which means
that at 90% and 95% confidence levels, the critical loss of the
hedging portfolio obtained by DCC-GARCH+ is lower than
that obtained by DCC-GARCH0 . We find that DCC-GARCH+
can reduce the portfolio exposure of the hedging portfolio
effectively and obtain a higher EU and Sp than that obtained by
DCC-GARCH0 . In general, compared with DCC-GARCH0 ,
the proposed DCC-GARCH+ has superior in-sample hedging
performance.
Then, we compare the two Markov DCC-GARCH mod-
els with other benchmark models. We can see from
Table V that compared with those benchmark models,
the values of VR, EU, and Sp obtained by the two
Markov DCC-GARCH models are all higher, and the val-
ues of VaR95% and VaR90% obtained by the two models
are all smaller. These studies show that compared with
traditional single-state hedging models, the two Markov
DCC-GARCH models exhibit superior in-sample hedging
performance.
2) Out-of-Sample Hedging Performance: As shown
in Table VI, we can see that compared with DCC-GARCH0 ,
the values of VR, EU, and Sp obtained by DCC-GARCH+
10
are also higher. Besides, the values of VaR95% and VaR90%
obtained by DCC-GARCH+ are also smaller than those
obtained by DCC-GARCH0 . The results show that DCC-
GARCH+ outperforms DCC-GARCH0 in an out-of-sample
forecasting period.
Then, we compare two Markov DCC-GARCH models with
other benchmark models. We can see from Table VI that com-
pared with those benchmark models, the value of EU obtained
by DCC-GARCH+ is the highest in all cases. Meanwhile,
the values of VR, Sp, VaR95% , and VaR90% obtained by DCC-
GARCH+ are the best in all cases except gold. The result of
DCC-GARCH0 is similar to that of DCC-GARCH+ . Overall,
DCC-GARCH+ performs worse than OLS regarding gold.
This observation may be due to the low conditional variance
of gold spot and futures in that period. In this case, compared
with time-varying hedging ratios, a static minimum variance
one may be better and gain better hedging performance.
The results of in-sample and out-of-sample hedging perfor-
mance show that the introduction of TVTP in a DCC-GARCH
model can effectively reduce portfolio risk and improve
expected utility. DCC-GARCH+ has the potential to compete
with other traditional static models in most cases. Furthermore,
this result provides a good hedging strategy for hedgers.
V. C ONCLUSION
In this article, we present a Markov regime switching
DCC-GARCH model with a TVTP and give an estima-
tion method of the minimum risk hedging ratio. A two-
stage maximum likelihood method is proposed to estimate
model parameters. Besides, the optimal hedging ratios of
four pairs of spots and futures including gold, silver, cop-
per, and aluminum are estimated in-sample and out-of-
sample. The performance of the hedging strategy is compared
with that of DCC-GARCH with fixed transition probabil-
ity, DCC-GARCH, OLS, 1:1 naïve hedging portfolio and
unhedged spots.
Empirical results from four commodity futures reveal that
DCC-GARCH models based on Markov regime switching
are suitable for studying the hedging problem in futures
market, and the fitting effect of a DCC-GARCH+ model
is the best. Regarding hedging performance, DCC-GARCH+
exhibits superior in-sample hedging effectiveness compared
with DCC-GARCH0 and other benchmark models for all the
commodities. For out-of-sample, DCC-GARCH+ also outper-
forms DCC-GARCH0 and other benchmark models in most
cases, except that it is inferior to OLS in gold. Thus, intro-
ducing TVTP to Markov DCC-GARCH can effectively reduce
portfolio risk, improve expected utility, and provide better
hedging performance than other traditional models. In some
cases, DCC-GARCH+ , DCC-GARCH0 . and DCC-GARCH all
perform worse than OLS. That could be due to the low volatil-
ities of spots and futures in that period. In this case, compared
with time-varying hedging ratios, a static minimum variance
one may be better and gain better hedging performance. Based
on this observation, we suggest that different models should be
used in place of a single one in commodity risk hedging since
they could perform differently according to different volatility
IEEE TRANSACTIONS ON AUTOMATION SCIENCE AND ENGINEERING
levels. This article is of guiding significance for hedgers to
fully understand the hedging rules of futures market and avoid
the risk of spots price.
Future research should introduce the psychological charac-
teristics of investors such as loss aversion and regret aversion
into the hedging models and analyze the effect of investors’
psychological factors on hedging strategies and hedging per-
formance from the perspective of behavioral finance. In addi-
tion, financial markets vary randomly. Thus fuzzy uncertainty
[38]–[44] can also be considered in the hedging models.
The robust optimization method could be used to study a
hedging portfolio strategy, which is also a meaningful research
direction. Besides, this article considers the time-varying prob-
ability by referring to the idea of Filardo (1994) and Simmons-
Süer (2018), in which logistic functions are used to describe
the time-varying characteristic. It is appropriate only for a
two-state Markov model. We plan to design a multi-state
Markov model with TVTP in the future research, and work
out if more states can improve the model performance.
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Jia Wang received the B.S. degree in economics
from Shenyang Agricultural University, Shenyang,
China, in 2009, and the M.S. degree in economics
and the Ph.D. degree in business administration
from Northeastern University, Shenyang, China,
in 2011 and 2015, respectively.
She is currently a Post-Doctoral Researcher with
Northeastern University. She is also a Lecturer
with the School of Economics, Northeastern Univer-
sity at Qinhuangdao, Qinhuangdao, China. She has
authored over ten publications including one book
and more than ten journal articles in her research areas. Her research focuses
on financial engineering, ambiguity decision, and risk management.
MengChu Zhou (S’88–M’90–SM’93–F’03)
received the B.S. degree in control engineering
from the Nanjing University of Science and
Technology, Nanjing, China, in 1983, the M.S.
degree in automatic control from the Beijing
Institute of Technology, Beijing, China, in 1986,
and the Ph. D. degree in computer and systems
engineering from the Rensselaer Polytechnic
Institute, Troy, NY, USA, in 1990.
He joined the New Jersey Institute of Technology
(NJIT), Newark, NJ, USA, in 1990. He is currently
a Distinguished Professor of Electrical and Computer Engineering. He has
authored over 800 publications including 12 books, more than 500 journal
articles (more than 400 in IEEE TRANSACTIONS ), and 29 book chapters,
and holds 12 patents. His research interests are in Petri nets, intelligent
automation, internet of things, big data, web services, and intelligent
transportation.
Dr. Zhou was a Lecturer in Australia, Canada, China, France, Germany,
Hong Kong, Italy, Japan, Korea, Mexico, Qatar, Saudi Arabia, Singapore,
Taiwan, and the USA. He served as a plenary/keynote speaker for many
conferences. He is a Life Member of the Chinese Association for Science
and Technology, USA, and served as its President in 1999. He is a fellow
of the International Federation of Automatic Control (IFAC), the American
Association for the Advancement of Science (AAAS), and the Chinese
Association of Automation (CAA). He is also VP for Conferences and
Meetings of the IEEE SMC Society. He was a recipient of the Humboldt
Research Award for U.S. Senior Scientists from Alexander von Humboldt
Foundation, the Franklin V. Taylor Memorial Award, the Norbert Wiener
Award from the IEEE Systems, Man, and Cybernetics Society, and the
Excellence in Research Prize and Medal from NJIT. He was the General
Chair of the 2006 IEEE International Conference on Networking, Sensing
and Control, Ft. Lauderdale, FL, USA, April 23–25, 2006, the IEEE
Conference on Automation Science and Engineering, Washington, DC, USA,
August 23–26, 2008, the General Co-Chair of the 2003 IEEE International
Conference on System, Man, and Cybernetics (SMC), Washington, DC,
USA, October 5–8, 2003, and the Founding General Co-Chair of the
2004 IEEE International Conference on Networking, Sensing and Control,
Taipei, Taiwan, March 21–23, 2004. He was the Program Chair of the
2010 IEEE International Conference on Mechatronics and Automation,
August 4–7, 2010, Xi’an, China, the 1998 and the 2001 IEEE International
Conference on SMC, and the 1997 IEEE International Conference on
Emerging Technologies and Factory Automation. He is the founding
Co-Chair of the Enterprise Information Systems Technical Committee (TC)
and Environmental Sensing, Networking, and the Decision-making TC of the
IEEE SMC Society. He has organized and chaired over 100 technical sessions
and served on program committees for many conferences. He has led or
participated in over 50 research and education projects with total budget over
U.S. $12 million, funded by the National Science Foundation, Department
of Defense, NIST, New Jersey Science and Technology Commission, and
industry. He has been among the most highly cited scholars for years
and ranked as the top one in the field of engineering worldwide in 2012
12
by Web of Science/Thomson Reuters and now Clarivate Analytics. He is
the Founding Editor of IEEE P RESS B OOK S ERIES ON S YSTEMS S CIENCE
AND E NGINEERING and the Editor-in-Chief of the IEEE/CAA J OURNAL OF
AUTOMATICA S INICA. He has served as an Associate Editor for the IEEE
T RANSACTIONS ON ROBOTICS AND AUTOMATION, the IEEE T RANSAC -
TIONS ON AUTOMATION S CIENCE AND E NGINEERING, the IEEE T RANS -
ACTIONS ON S YSTEMS , M AN AND C YBERNETICS : S YSTEMS , and the IEEE
T RANSACTIONS ON I NDUSTRIAL I NFORMATICS , and an Editor of the IEEE
T RANSACTIONS ON AUTOMATION S CIENCE AND E NGINEERING. He has
served as a Guest Editor for many journals, including the IEEE I NTERNET
OF T HINGS J OURNAL, the IEEE T RANSACTIONS ON I NDUSTRIAL E LEC -
TRONICS , and the IEEE T RANSACTIONS ON S EMICONDUCTOR M ANU -
FACTURING . He is also an Associate Editor of the IEEE T RANSACTIONS
ON I NTELLIGENT T RANSPORTATION S YSTEMS , the IEEE I NTERNET OF
T HINGS J OURNAL, and the Frontiers of Information Technology & Electronic
Engineering.
Xiu Jin received the B.S. degree in manage-
ment engineering from Northeastern University,
Shenyang, China, in 1984, the M.S. degree in sta-
tistics from the Dongbei University of Finance and
Economics, Dalian, China, in 1990, and the Ph.D.
degree in management science and engineering from
Northeastern University, Shenyang, in 2006.
She joined Northeastern University, Shenyang,
in 1984, where she is currently a Professor of
Finance. She has authored over 100 publications
including three books, more than 100 journal articles
in her research areas. Her research interests are in financial engineering, capital
market, and portfolio optimization.
Xiwang Guo received the B.S. degree in computer
science and technology from the Shenyang Institute
of Engineering, Shenyang, China, in 2006, the M.S.
degree in aeronautics and astronautics manufactur-
ing engineering from Shenyang Aerospace Univer-
sity, Shenyang, in 2009, and the Ph.D. degree in
system engineering from Northeastern University,
Shenyang, in 2015.
He is currently a Lecturer with the College of
Computer and Communication Engineering, Liaon-
ing Shihua University, Fushun, China. He is also a
Visiting Scholar with the Department of Electrical and Computer Engineering,
New Jersey Institute of Technology, Newark, NJ, USA. He has authored
over 20 journal and conference proceedings articles in his research areas.
His research focuses on remanufacturing, recycling and reuse of automotive,
and intelligent optimization algorithm.
IEEE TRANSACTIONS ON AUTOMATION SCIENCE AND ENGINEERING
Liang Qi (S’16–M’18) received the B.S. degree in
information and computing science and the M.S.
degree in computer software and theory from the
Shandong University of Science and Technology,
Qingdao, China, in 2009 and 2012, respectively, and
the Ph.D. degree in computer software and theory
from Tongji University, Shanghai, China, in 2017.
From 2015 to 2017, he was a Visiting Student
with the Department of Electrical and Computer
Engineering, New Jersey Institute of Technology,
Newark, NJ, USA. He is currently with the Shan-
dong University of Science and Technology, Qingdao. He has authored more
than 30 technical articles in journals and conference proceedings, including
the IEEE T RANSACTIONS ON S YSTEM , M AN AND C YBERNETICS : S YS -
TEMS , the IEEE T RANSACTIONS ON I NTELLIGENT T RANSPORTATION S YS -
TEMS , and the IEEE/CAA J OURNAL OF AUTOMATICA S INICA . His interests
include Petri nets, machine learning, intelligent transportation systems, and
optimization.
Dr. Qi received the Best Student Paper Award-Finalist in the 15th IEEE
International Conference on Networking, Sensing and Control (ICNSC’2018).
Xu Wang received the B.S. degree in automation
and the M.S. degree in control theory and
control engineering from the Liaoning University
of Technology, Jinzhou, China, in 2006 and
2010, respectively, and the Ph.D. degree in
system engineering from Northeastern University,
Shenyang, China, in 2017.
He is currently a Lecturer with the School of
Economics, Hebei University of Environment
Engineering, Qinhuangdao, China. He has authored
over 10 journal and articles in his research areas. His
research focuses on logistics and supply chain management, project manage-
ment and human resource optimization, and intelligent optimization algorithm.