Working Paper Series no. 191: Switching VARMA Term Structure Models - Extended Version

Abstract

The purpose of the paper is to propose a global discrete-time modeling of the term structure of interest rates able to capture simultaneously the following important features : (i) an historical dynamics of the factor driving term structure shapes involving several lagged values, and switching regimes; (ii) a specification of the stochastic discount factor (SDF) with time-varying and regime dependent risk-premia; (iii) explicit or quasi explicit formulas for zero-coupon bond and interest rate derivative prices; (iv) the positivity of the yields at each maturity. The first family of models we develop is given by the Switching Autoregressive Normal (SARN) and the Switching Vector Autoregressive Normal (SVARN) Factor-Based Term Structure Models of order p. The second family of models we study is given by the Switching Autoregressive Gamma (SARG) and the Switching Vector Autoregressive Gamma (SVARG) Factor-Based Term Structure Models of order p. Regime shifts are described by a Markov chain with (historical) non-homogeneous transition probabilities.

Alain Monfort and Fulvio Pegoraro
December 2007

Classification JEL : C1, C5, E43, G12.

Keywords : Affine Term Structure Models, Stochastic Discount Factor, Car processes, Switching Regimes, VARMA processes, Lags, Positivity, Derivative Pricing.