Hidden Markov Models as a Tool for the Assessment of Dependence of Phenomena of Economic Nature

Abstract

The assessment of dependence between time series is a common dilemma, which is often solved by the use of the Pearson’s correlation coefficient. Unfortunately, sometimes, the results may be highly misleading. In this paper, an alternative measure is presented. It is based on hidden Markov models and Viterbi paths. The proposed method is in no way universal but seems to provide quite an accurate image of the similarities between time series, by disclosing the periods of convergence and divergence. The usefulness of this new measure is verified by specially crafted examples and real‑life macroeconomic data. There are some definite advantages to this method: the weak assumptions of applicability, ease of interpretation of the results, possibility of easy generalization, and high effectiveness in assessing the dependence of different time series of an economic nature. It should not be treated as a substitute for the Pearson’s correlation, but rather as a complementary method of dependence measure.