Why are Markov chains widely used in risk modelling despite markets not being memoryless?

Conditions

• Used as a modelling framework rather than as an exact description of markets.
• The goal is parsimonious representation of persistence and regime changes.

Reasoning, step by step

1. Reject the misconception that Markov chains are used because markets have no memory.
2. Identify the actual reasons: capturing persistence, regime behaviour, and long-run risk.
3. Note that they require minimal assumptions.
4. Conclude that they offer a balance between analytical tractability and structural richness.

Example

The narrator states: 'Not because they are perfect, but because they capture persistence, regime behaviour, and long-run risk with minimal assumptions.'

Common misconceptions

• Believing that Markov chains are used because markets are literally memoryless.
• Assuming that Markov chains are perfect descriptions of market dynamics.

Watch the explanation

Explore next

• What applications rely on Markov chains at their core?
• What happens when we observe the system for a long time?
• What is the central limit theorem previewed in the video?