Conditional Markov regime switching model applied to economic modelling
AbstractIn this paper we discuss the calibration issues of regime switching models built on mean-reverting and local volatility processes combined with two Markov regime switch- ing processes. In fact, the volatility structure of this model depends on a first exogenous Markov chain whereas the drift structure depends on a conditional Markov chain with re- spect to the first one. The structure is also assumed to be Markovian and both structure and regime are unobserved. Regarding this construction, we extend the classical Expectation- Maximization (EM) algorithm to be applied to our regime switching model. We apply it to economic datas (Euro-Dollars foreign exchange rate and Brent oil price) to show that this modelling well identifies both mean reverting and volatility regimes switches. More- over, it allows us to give economic interpretations of this regime classification such as some financial crisis or some economic policies.
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Date of creation: 31 Oct 2012
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Markov regime switching; Expectation-Maximization algorithm; mean-reverting; local volatility; economics data.;
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-11-11 (All new papers)
- NEP-ECM-2012-11-11 (Econometrics)
- NEP-ETS-2012-11-11 (Econometric Time Series)
- NEP-ORE-2012-11-11 (Operations Research)
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