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Markov Switching Applications

Strong research and testing methods are the backbone of DEFINIT and we strives to provide research-based consultancies and policy recommendations to its clients. Therefore, we keep strengthening the research and analytical capacity of its researchers through various capacity building programs and internal (in-house) research practices on the most up-to-date research methods and modeling.

One of the internal research papers to be prepared by DEFINIT is the application of Markov-Switching models and its variants/extensions to model the Asian economic crises and the recent global crisis. Markov-Switching model is an alternative framework for two approaches commonly used to early warning systems for financial crises, i.e the Signal Approach by Kaminsky, Lizondo, and Reinhart (1998) and the Probit/Logit Approach.

The Markov-Switching Model offers several advantages to be used as an early warning system. First, it allows the calculation of the predicted probabilities of a crisis. Second, it can model variables that exhibit sudden and dramatic changes and does not require prior definition of crisis period and normal period. Third, it can tell us the dynamics of crises in terms of when a crises will likely to occur, how long it will tend to last, and what variables might bring a crises to an end.

The Markov-Switching Model has been developed and extended by combining the Markov-Switching Model with other approaches. One of the approach is the Markov-Switching Model with time-varying transition. The founder of DEFINIT, Bagus Santoso, together with J.L Ford and N.J. Horsewood (2007) from the Department of Economics, the University of Birmingham, used this framework in modeling the Asian currency crisis 1997. They combined the Markov-Switching Model with the Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model to explain the market pressure on the exchange rate and the probability of the timing of a crisis. Their paper can be downloaded at the following link: ftp://ftp.bham.ac.uk/pub/RePEc/pdf/PAPER7.pdf

DEFINIT research will replicate the study by Ford, Santoso, and Horsewood (2007) with several adjustments. The research will also try to model the recent global crisis by using the Markov-Switching model.

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