Short Rate Dynamics and Regime Shifts
University of Michigan - Stephen M. Ross School of Business; Cheung Kong Graduate School of Business; Cheung Kong Graduate School of Business
Teachers Insurance and Annuity Association College Retirement Equities Fund (TIAA-CREF)
International Review of Finance, Vol. 9, Issue 3, pp. 211-241, September 2009
We characterize the dynamics of the US short-term interest rate using a Markov regime-switching model. Using a test developed by Garcia, we show that there are two regimes in the data: In one regime, the short rate behaves like a random walk with low volatility; in another regime, it exhibits strong mean reversion and high volatility. In our model, the sensitivity of interest rate volatility to the level of interest rate is much lower than what is commonly found in the literature. We also show that the findings of nonlinear drift in Aït-Sahalia and Stanton, using nonparametric methods, are consistent with our regime-switching model.
Number of Pages in PDF File: 31Accepted Paper Series
Date posted: October 13, 2009
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