Short Rate Dynamics and Regime Shifts

45 Pages Posted: 12 Oct 2002

See all articles by Yuewu Xu

Yuewu Xu

Teachers Insurance and Annuity Association College Retirement Equities Fund (TIAA-CREF)

Haitao Li

University of Michigan - Stephen M. Ross School of Business; Cheung Kong Graduate School of Business; Cheung Kong Graduate School of Business

Abstract

We characterize the dynamics of the U.S. short-term interest rate using a Markov regime switching model. Using a test developed by Garcia (1998), 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 Ait-Sahalia (1996b) and Stanton (1997), using nonparametric methods, are consistent with our regime switching model.

Keywords: Regime Switching, Likelihood Ratio Test, Nonlinear Drift

JEL Classification: C4, E4, G0

Suggested Citation

Xu, Yuewu and Li, Haitao, Short Rate Dynamics and Regime Shifts. Available at SSRN: https://ssrn.com/abstract=327423 or http://dx.doi.org/10.2139/ssrn.327423

Yuewu Xu (Contact Author)

Teachers Insurance and Annuity Association College Retirement Equities Fund (TIAA-CREF) ( email )

730 Third Avenue
New York, NY 10017-3206
United States

Haitao Li

University of Michigan - Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-615-5475 (Phone)

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

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