Conditional Markov regime switching model applied to economic modelling

Abstract

In this paper we discuss the calibration issues of regime switching models built on mean-reverting and local volatility processes combined with two Markov regime switching processes. In fact, the volatility structure of these models depends on a first exogenous Markov chain whereas the drift structure depends on a conditional Markov chain with respect 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 data (Euro/Dollar (USD) foreign exchange rate and Brent oil price) to show that such modelling clearly identifies both mean reverting and volatility regime switches. Moreover, it allows us to make economic interpretations of this regime classification as in some financial crises or some economic policies.