Hedging Climate Change News With Commodity Futures: An Index-Tracking Approach

Abstract

We propose and implement a trading strategy based on the index-tracking approach to build portfolios that hedge climate risk using commodity futures. We consider the climate change news index of Engle et al. to derive the hedge target. The empirical results suggest that the index-tracking approach performs well in constructing climate change hedge portfolios. The short-selling constraint enhances the out-of-sample hedge performance due to the alleviation of overfitting. The hedge performance indicates that commodity futures could be effective tools for hedging climate risk. We further reveal the heterogeneous roles of commodity futures in hedging climate risk. Our work provides an effective strategy for constructing climate change hedge portfolios and highlights the important and potential role of commodity futures in the era of climate change.