## Term Structure of Interest Rates with Regime Shifts (2002)

Citations: | 78 - 1 self |

### BibTeX

@MISC{Bansal02termstructure,

author = {Ravi Bansal and Hao Zhou},

title = {Term Structure of Interest Rates with Regime Shifts},

year = {2002}

}

### Years of Citing Articles

### OpenURL

### Abstract

We develop a term structure model where the underlying short term interest rate and the market price of risk are modeled as square-root processes which are subject to discrete regime shifts. Our model captures the idea that the aggregate economy is subject to risks from discrete and persistent changes in the business cycle. We provide a solution for the nominal default-free yield curve in this economic environment. Exploiting these analytical solutions we estimate our model via the Efficient Method of Moments (EMM) using short and long interest rate data from 1964 to 1995. Our empirical evidence provides considerable support to the regime shifts model. Standard term structure models, which includes affine models with up to three factors, are sharply rejected in the data. Our diagnostics, based on computing the model-based transition density for yields, show that only the regime switching model can reasonably justify the observed conditional volatility and conditional correlation of yields....