Analyzing Oil Price Shocks and Exchange Rates Movements in Korea using Markov Regime-Switching Models

Abstract

Korea imports all of its crude oil, and is the world's fifth largest oil importing country. We analyze the effects of oil prices, interest rates, consumer price indexes (CPIs), and industrial production indexes (IPIs) on the regime shift behavior of the Korean exchange rates against the USA from January 1991 to March 2019. We use the Markov regime switching model (MRSM) to detect the regime shift behavior of the movements of Korean exchange rates. In order to select the optimal MRSM, we fit a total of 30 models considering four explanatory variables. The selected model based on Akaike information criteria (AIC) and maximum log likelihood (MLL) includes the log-differentials of oil prices, the log-differentials of CPIs compared to those of the US, and its own auto-regressive terms. Based on the selected MRSM model, throughout all markets, we find evidence to support the existence of two distinct regimes: a stable regime with low-volatility, and an unstable regime with high-volatility. The regime with high-volatility includes the Asian financial crisis of 1997 and the global financial crisis of 2008–2009 in the Korean exchange rates market. In the regime with low-volatility, the Korean exchange rates are not significantly influenced by any of the explanatory variables, except for its own auto-regressive terms. In the regime with high-volatility, the Korean exchange rates are significantly influenced by the CPIs and oil prices. The transition probability from the regime with low-volatility to the regime with high-volatility is about ten times that of the opposite case.