Are categorical EPU indices predictable for carbon futures volatility? Evidence from the machine learning method

ABSTRACT

The purpose of this paper is to explore whether the categorical Economic Policy Uncertainty (EPU) indices are predictable for the volatility of carbon futures, in the mixed data sampling (MIDAS) regression framework. The prediction methods include the MIDAS-RV model, the MIDAS models extended by individual categorical EPU index, combination prediction approaches, the MIDAS models extended by dimensionality reduction techniques as well as the machine learning methods on the basis of MIDAS model and Markov regime switching method. We find firstly that categorical EPU indices are predictable for carbon futures volatility, but the predictive power of individual categorical EPU indices is not robust. Secondly, machine learning methods, especially the machine learning method considering the Markov regime switching structure, help to obtain valid information from multiple categorical EPU indices and produce robust and superior prediction accuracy for carbon futures volatility. The results of the extension analysis also found that machine learning methods, especially the machine learning method considering the Markov regime switching structure help to produce higher investment performance and more accurate long-term carbon futures volatility forecasts. Meanwhile, we also find the advantages of the MIDAS based machine learning methods over the traditional AR based machine learning methods. Finally, the forecasting performance of the machine learning method which considering Markov regime switching structure are superior during both the low and high volatility regimes and even during the COVID-19 pandemic.