Term Structure of Interest Rates with Regime Shifts

Abstract

We develop a term structure model where the short interest rate and the market price of risks are subject to discrete regime shifts. Empirical evidence from Efficient Method of Moments estimation provides considerable support for the regime shifts model. Standard models, which include affine specifications with up to three factors, are sharply rejected in the data. Our diagnostics show that only the regime shifts model can account for the well documented violations of the expectations hypothesis, the observed conditional volatility, and the conditional correlation across yields. We find that regimes are intimately related to business cycles.

New Numerical Scheme for Pricing American Option With Regime-Switching

“…A frequently observed phenomenon is that a transition between business cycle expansion and contraction usually leads to significant changes in stock returns, interest rates and other financial indices. These changes exhibit certain cyclic or periodic patterns (see Bansal and Zhou [2]). Reasonably, the dynamic changes of asset prices can be better described by models that incorporate a regime-switching component.…”

“…Reasonably, the dynamic changes of asset prices can be better described by models that incorporate a regime-switching component. Empirical studies have provided considerable support for including regime-switching in both equity models (Hardy [13]) and interest rate models [2], especially when long terms are under consideration.…”

A General Equilibrium Model of the Term Structure of Interest Rates Under Regime-Switching Risk

“…1 These results have motivated the recent studies of the impact of regime shifts on the entire yield curve using dynamic term structure models. A common approach, as in Naik and Lee [35], Boudoukh et al [6], Evans [20] and Bansal and Zhou [3], is to incorporate Markov-switching into the stochastic processes of the pricing kernel and/or state variables. 2 The regime-dependence introduced by these studies implies richer dynamic behavior of the market price of risk and therefore offers greater econometric flexibility for the term structure models to simultaneously account for the time series and cross-sectional properties of interest rates.…”

“…However, most of these studies (see, for example, [3]) have also shown that regimes are intimately related to the business cycle, suggesting a close link between the regime shift and aggregate uncertainties. 3 Hence it is most likely that the Markov regime shifts represent a systematic risk which should be priced in the term structure models.…”

“…We further obtain a closed-form solution of the term structure of interest rates under an affine-type model using the log-linear approximation similar to that in Bansal and Zhou [3]. The model is estimated by Efficient Method of Moments (EMM) developed in Bansal et al [4] and Gallant and Tauchen [24,26].…”