Term Structure of Interest Rates with Regime Shifts

by Ravi Bansal of Duke University, and
Hao Zhou of the Federal Reserve Board

August 2001

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.

Keywords: Regime switching, term structure of interest rate, reprojection, efficient method of moments.

Published in: Journal of Finance, Vol. 57, No. 5, (October 2002), pp. 1997-2043.

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