Regime Switching Stochastic Volatility and Short-Term Interest Rates

Abstract

In this paper, we introduce regime-switching in a two-factor stochastic volatility (SV) model to explain the behavior of short-term interest rates. We model the volatility of short-term interest rates as a stochastic volatility process whose mean is subject to shifts in regime. We estimate the regime-switching stochastic volatility (RSV) model using a Gibbs Sampling-based Markov Chain Monte Carlo algorithm. In-sample results strongly favor the RSV model in comparison to the single-state SV model and GARCH family of models. Out-of-sample results are mixed and, overall, provide weak support for the RSV model.

JEL Classification: G10, G12