Keywords: Regime switching, term structure of interest rate, expectation hypothesis, business cycle, efficient method of moments.
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, and 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.
Full paper (265 KB PDF)
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Last update: June 9, 2003