Switching Varma Term Structure Models

Posted: 16 Jun 2008

See all articles by Alain Monfort

Alain Monfort

National Institute of Statistics and Economic Studies (INSEE) - Center for Research in Economics and Statistics (CREST); National Bureau of Economic Research (NBER); Maastricht University

Fulvio Pegoraro

Banque de France - Economics and Finance Research Center; CREST - Laboratoire de Finance et Assurance

Multiple version iconThere are 2 versions of this paper

Date Written: Winter 2007

Abstract

The purpose of this article is to propose a global discrete-time modeling of the term structure of interest rates which is able to capture simultaneously the following important features: (i) a historical dynamics of the factor driving term structure shapes involving several lagged values, and switching regimes; (ii) a specification of the stochastic discount factor (SDF) with time-varying and regime-dependent risk-premia; (iii) explicit or quasi explicit formulas for zero-coupon bond (ZCB) and interest rate derivative prices. We develop the switching autoregressive normal (SARN) and the switching vector autoregressive normal (SVARN) Factor-Based Term Structure Models of order p. The factor is considered as a latent variable or an observable variable: in the second case the factor is a vector of several yields. Regime shifts are described by a Markov chain with (historical) nonhomogeneous transition probabilities. An empirical analysis of bivariate VAR(p) and SVARN(p) Factor-Based Term Structure Models, using monthly observations of the U.S. term structure of interest rates, and a goodness-of-fit and expectation hypothesis puzzle comparison with competing models in the literature, shows the determinant role played by the observable nature of the factor, lags, and switching regimes in the term structure modeling.

Keywords: affine term structure models, Car(p) processes, expectation hypothesis puzzle, lags, stochastic discount factor, switching regimes, VARMA processes

Suggested Citation

Monfort, Alain and Pegoraro, Fulvio, Switching Varma Term Structure Models (Winter 2007). Journal of Financial Econometrics, Vol. 5, Issue 1, pp. 105-153, 2007, Available at SSRN: https://ssrn.com/abstract=1145508 or http://dx.doi.org/10.1093/jjfinec/nbl009

Alain Monfort (Contact Author)

National Institute of Statistics and Economic Studies (INSEE) - Center for Research in Economics and Statistics (CREST) ( email )

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Fulvio Pegoraro

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