Tuesday, February 20 at 2 pm

Ruey S. Tsay, H.G.B. Alexander Professor of Econometrics and Statistics Graduate School of Business, The University of Chicago Title: The Dynamics of Threshold Interest Rate Models (Joint with Shang C. Chiou)

We propose a two-factor arbitrage-free term structure model for interest rates, where the short-term interest rate follows a threshold model with stochastic volatility. Under the proposed model, the number of thresholds is unknown and must be endogenously determined by a model selection procedure. To estimate the proposed model, we develop an efficient Bayesian method by transforming the threshold problem into a structural-break problem. Simulation study shows that the proposed Bayesian method provides an accurate estimation of the thresholds and the associated parameters of the model. In applications, the U.S. data strongly favor the newly proposed model over other models with constant volatility. We further compare the threshold model to its affine counterpart and the Markov-switching model, demonstrating the significant difference of using the thresholds. We find that the threshold model built implies a kinked yield function and can generate an inverted yield curve. In addition, for U.S. monthly bond yields with 11 maturities (1 to 6 months and 1 to 5 years), the threshold model has smaller out-of-sample pricing errors than other models, especially for the long-term yields.

Created by Noelle I. Samia
Last Updated 01/08/2007