An Econometric Model of the Term Structure of Interest Rates Under Regime-Switching Risk

Abstract

AbstractThis paper develops and estimates a continuous-time model of the term structure of interests under regime shifts. The model uses an analytically simple representation of Markov regime shifts that elucidates the effects of regime shifts on the yield curve and gives a clear interpretation of regime-switching risk premiums. The model falls within the broad class of essentially affine models with a closed form solution of the yield curve, yet it is flexible enough to accommodate priced regime-switching risk, time-varying transition probabilities, regime-dependent mean reversion coefficients as well as stochastic volatilities within each regime. A two-factor version of the model is implemented using Efficient Method of Moments. Empirical results show that the model can account for many salient features of the yield curve in the U.S.KeywordsInterest RateRisk PremiumTerm StructureYield CurveRegime ShiftThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.