Regime-Shifts, Risk Premiums in the Term Structure, and the Business Cycle

Duke University, Economics Working Paper

33 Pages Posted: 26 Jun 2003

See all articles by Ravi Bansal

Ravi Bansal

Duke University and NBER

George Tauchen

Duke University - Economics Group

Hao Zhou

Tsinghua University - PBC School of Finance

Date Written: October 15, 2003

Abstract

We examine various dynamic term structure models for monthly US Treasury yields from 1964 to 2001. Of particular interest is the predictability of bond excess returns. Recent evidence indicates that using multiple forward rates can sharply predict future excess returns on bonds; the R2 of this predictability regression can be as high as 30%. In addition, the projection coefficients in these predictability regressions exhibit a tent shaped pattern that relates to the maturity of the forward rate. This dimension of the data in conjunction with the transition dynamics of bond yields (i.e., conditional volatility and cross-correlation of bond yields) poses an serious challenge to term structure models. In this paper we present and estimate a regime-shifts term structure model - our findings show that this model can account for all aspects of the predictability regression and the transition dynamics of yields. Alternative models, such as, affine factor models cannot account for these features of the data. We find that the regimes in the model are related to the NBER business cycle indicator.

Keywords: Term Structure of Interest Rates, Yield Curve, Regime Switching, Risk Premium, Expectation Hypothesis, Business Cycle, Efficient Method of Moments, EMM

JEL Classification: E43, G12, C51, C52

Suggested Citation

Bansal, Ravi and Tauchen, George E. and Zhou, Hao, Regime-Shifts, Risk Premiums in the Term Structure, and the Business Cycle (October 15, 2003). Duke University, Economics Working Paper, Available at SSRN: https://ssrn.com/abstract=400040 or http://dx.doi.org/10.2139/ssrn.400040

Ravi Bansal

Duke University and NBER ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7758 (Phone)
919-660-8038 (Fax)

George E. Tauchen (Contact Author)

Duke University - Economics Group ( email )

Box 90097
221 Social Sciences
Durham, NC 27708-0097
United States
919-660-1812 (Phone)
919-684-8974 (Fax)

Hao Zhou

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengfu Road
Haidian District
Beijing, 100083
China
86-10-62790655 (Phone)

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