Markov Switching Risk Premium and the term structure of interest rates. Empirical evidence from US post-war interest rates

This paper considers the basic present value model of interest rates under rational expectations with two additional features. First, following McCallum (1994), the model assumes a policy reaction function where changes in the short-term interest rate are determined by the long-short spread. Second, the short-term interest rate and the risk premium processes are characterized by a Markov regime-switching model. Using US post-war interest rate data, this paper finds evidence that a two-regime switching model fits the data better than the basic model. The estimation results also show the presence of two alternative states displaying quite different features.Financial support from Ministerio de Ciencia y Tecnología, Gobierno Vasco and Universidad del País Vasco (Spain) through projects BEC2000-1393, PI-1999-131 and 9/UPV0035.321-13511/2001, respectively, is gratefully acknowledged