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Term Structure Modeling with Structural Breaks: A Simple Arbitrage-Free Approach

40 Pages Posted: 18 Dec 2011 Last revised: 19 Nov 2012

Wachi Bandara

Pluribus Labs

Richard Munclinger

Federal Home Loan Mortgage Corporation (FHLMC)

Date Written: December 17, 2011

Abstract

Economic time-series are susceptible to infrequent but severe structural breaks that stem from banking crises, changes in government policy or shifts in consumer con fidence. We present an affine, arbitrage-free, regime-switching dynamic Nelson-Siegel model of the term structure that identifies structural breaks. We develop the model in continuous time and present a class of general affine hidden Markov models of the term structure. We highlight the assumptions that are necessary to reach tractable versions in this class such as the Dai, Singleton and Yang (2007) model and the arbitrage-free regime-switching Nelson and Siegel model. We estimate an arbitrage-free hidden Markov Nelson Siegel model on historical yield curve data via a multi-regime approximate Kalman filter. We contrast the model to single-regime alternatives and conclude that our model performs better in-sample. Using likelihood ratio tests, we show that regimes are driven by long term means, mean reversions, measurement and transition covariance matrices. The regimes conform to periods of expansionary and restrictive monetary policy, but do not coincide exactly with recessions. Our regimes capture the NBER recession dates, but persist long after the recessions have ended.

Keywords: Term structure, Nelson-Siegel models, regime switching, arbitrage free models

JEL Classification: C53, C58, E43

Suggested Citation

Bandara, Wachi and Munclinger, Richard, Term Structure Modeling with Structural Breaks: A Simple Arbitrage-Free Approach (December 17, 2011). Available at SSRN: https://ssrn.com/abstract=1974033 or http://dx.doi.org/10.2139/ssrn.1974033

Wachindra Bandara (Contact Author)

Pluribus Labs ( email )

1331 7th St.
Berkeley, CA 94710
United States

Richard Munclinger

Federal Home Loan Mortgage Corporation (FHLMC) ( email )

8200 Jones Branch Road
McLean, VA 22101
United States

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