An Extension of the Markov-Switching Model with Time-Varying Transition Probabilities: Bull-Bear Analysis of the Japanese Stock Market

first draft: November 1, 2004This paper attempts to extend the Markov-switching model with time-varying transition probabilities (TVTP). The transition probabilities in the conventional TVTP model are functions of exogenous variables that are time-dependent but with constant coefficients. In this paper the coefficient parameters that express the sensitivities of the exogenous variables are also allowed to vary with time. Using data on Japanese monthly stock returns, it is shown that the explanatory power of the extended model is superior to conventional models.21世紀COEプログラム = 21st-Century COE Program25 p