Green bonds and implied volatilities: Dynamic causality, spillovers, and implications for portfolio management

Abstract

The long-term and sustainable development focuses of green bond together with its increasing popularity drives the need for a better understanding of its hedging effects against market risks. Our study investigates whether and how green bond can act as a hedging instrument against implied volatility, a measure of forward-looking market uncertainty. We find evidence of significant time-varying connectedness between green bond and implied volatilities of the stock, energy, and commodity markets. Building on this characteristic, investors are required to adopt an active portfolio management strategy to ensure the hedging effectiveness of green bond against implied volatilities. Specifically, this strategy requires frequent switches between long and short positions in the green bond market. Our simple simulation study shows evidence that applying connectedness regime-dependent trading strategies can increase the hedging effectiveness of green bond against implied volatilities in terms of risk-adjusted returns.