Correcting estimation bias in regime switching dynamic term structure models

Sungjun Cho, Liu Liu

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Abstract

This paper extends the minimum-chi-square estimation for affine term structure models to a regime switching framework, and corrects the estimation bias in the regime switching dynamic term structure model. Biases arise as a result of highly persistent bond yields, and bias correction changes the decomposition of medium- and long-term forward rates. The bias-corrected expected short rate accounts for the pronounced moves in forward rates during the 1979–1982 monetary experiment and the financial crisis. The bias-corrected term premium becomes counter-cyclical and more negatively correlated with the short-term yield. Monte Carlo simulation shows that the decomposition of forward rates is more accurate after bias correction.
Original languageEnglish
Pages (from-to)1093-1127
Number of pages35
JournalReview of Quantitative Finance and Accounting
Volume61
Early online date20 Jul 2023
DOIs
Publication statusPublished - 1 Oct 2023
Event10th International Conference on Computational and Financial Econometrics - Paris, France
Duration: 20 Dec 2016 → …

Keywords

  • Regime switching
  • Small sample bias correction
  • Term structure

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