A Regime-Switching Nelson--Siegel Term Structure Model and Interest Rate Forecasts

Ju Xiang and Xiaoneng Zhu

Journal of Financial Econometrics, 2013, vol. 11, issue 3, 522-555

Abstract: This article presents a dynamic Nelson--Siegel term structure model subject to regime shifts. To estimate the model, we introduce the reversible jump Markov chain Monte Carlo method, which allows jumps between the one-, two-, and three-regime models. The empirical results support the two-regime Nelson--Siegel term structure model. The empirical results also suggest that the regime-switching Nelson--Siegel term structure model forecasts better out-of-sample than the single-regime Nelson--Siegel model and other competing models. In addition, our economic analysis is favorable to the better forecasting performance of the regime-switching Nelson--Siegel model. Using the Diebold-Li bond yields, we find that the better forecasting performance is robust. Finally, two regimes are found to be related to business cycle conditions and monetary policy. Copyright The Author, 2013. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oup.com, Oxford University Press.

Date: 2013
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