A study on the market instability index and risk warning levels in early warning system for economic crisis

Early warning system (EWS) can be treated as a pattern recognition problem since the distinctive feature of economic crisis makes it possible to distinguish critical and normal economic situations using a pattern classifier. Although the most works in EWS are mainly focused on training and pattern classifier, little attention has been paid to the effective indices or feature variables that allow closer look and analysis about the current instability nature of the economic crisis. This paper proposes to utilize market instability index (MII) and stepwise risk warning levels that can diagnose the current instability of the stock market to foretell how the current stock market will proceed in advance. This approach allows the proper policy actions to be taken for the possible financial crisis according to different risk warning levels of instability. Through empirical examples with Korean stock market and Greece stock market, the proposed method demonstrates its potential usefulness in an early warning system.