Markov Chains in Predictive Models of Currency Crises - with Applications to Southeast Asia

35 Pages Posted: 27 May 2002

See all articles by Roberto S. Mariano

Roberto S. Mariano

Singapore Management University

Abdul G. Abiad

International Monetary Fund (IMF) - Research Department

Bulent Gultekin

University of Pennsylvania - Finance Department

Tayyeb Shabbir

University of Pennsylvania - Department of Economics

Augustine H.H. Tan

Singapore Management University - School of Social Sciences

Date Written: May 2002

Abstract

A Markov regime switching model for exchange rate fluctuations, with time-varying transition probabilities, is used in constructing a monthly model for predicting currency crises in Southeast Asia. The approach is designed to avoid the estimation inconsistency that might arise from misclassification errors in the construction of crisis dummy variables which other approaches (such as probit/logit and signaling) require. Our methodology also addresses the serial correlations and sudden behavior inherent in crisis occurrence, identifies a set of reliable and observable indicators of impending crisis difficulties, delivers forecast probabilities of future crises over multi-period forecasting horizons, and offers an empirical framework for analyzing contagion effects of a crisis. Our empirical results indicate that the Markov switching model is moderately successful at predicting crisis episodes, but also points to future research in various directions. Most early warning systems for currency crises have used either probit or signaling. Several issues can be raised regarding these techniques: the need for a priori dating of crisis occurrence, the use of arbitrary thresholds, inadequate modeling of the dynamics in the system, among others. We present an alternative framework, based on a Markov-switching model of exchange rate fluctuations with time-varying transition probabilities, which addresses these concerns.

Suggested Citation

Mariano, Roberto S. and Abiad, Abdul G. and Gultekin, Bulent and Shabbir, Tayyeb and Tan, Augustine H.H., Markov Chains in Predictive Models of Currency Crises - with Applications to Southeast Asia (May 2002). PIER Working Paper No. 02-013. Available at SSRN: https://ssrn.com/abstract=313837 or http://dx.doi.org/10.2139/ssrn.313837

Roberto S. Mariano (Contact Author)

Singapore Management University ( email )

50 Stamford Rd.
Singapore 912409, 178899
Singapore

Abdul G. Abiad

International Monetary Fund (IMF) - Research Department ( email )

700 19th Street NW
Washington, DC 20431
United States

Bulent Gultekin

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-4505 (Phone)
215-898-6200 (Fax)

Tayyeb Shabbir

University of Pennsylvania - Department of Economics ( email )

3718 Locust Walk
334 McNeil Building
Philadelphia, PA 19104
United States
215-898-7787 (Phone)
215-573-2057 (Fax)

Augustine H.H. Tan

Singapore Management University - School of Social Sciences ( email )

Tanglin P.O. Box 257
Singapore 912409
Singapore
+65 6822 0379 (Phone)
+65 6822 0101 (Fax)

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