Currency Crises Models for Emerging Markets
In this paper, a new method is introduced to predict currency crises. The method models a continuous crisis index, based on depreciations and reserve losses. The fact that during currency crises, the behaviour of market participants differs from normal circumstances is modelled by means of model with two regimes, one for troubled, and one for normal times. Both the probability of entering the crisis regime, and the expected depreciation and volatility in this regime depend on economic circumstances. The probability of crisis can be explained by the real exchange rate, the inflation rate, the growth of the short-term debt over reserves ratio, the reserves over M2 ratio, and the imports over exports ratio, whereas the depth of a crisis is primarily related to local depreciations and the short term debt over reserves ratio. The most important factors for explaining current month's crisis index are recent changes in the exchange rate and reserves themselves however. The model is reasonably successful in predicting currency crises, also out of sample.
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