Regime Shifts, Risk and the Term Structure

Abstract

This paper develops and estimates a general equilibrium model for the term structures of nominal and real interest rates that incorporates regime-switching into the dynamics of the state variables. The model generates time-varying risk premia via changes in the covariance structure of the state variables and Peso problems through regime-switching. When the model is estimated using real and nominal yields from the U.K., I find that Peso problems emanating from instability in inflation have a significant impact on the nominal term structure. Peso problems affect (i) the sample predictability of excess returns, (ii) nominal term premia, and (iii) the inflation risk premia linking real and nominal yields with expected inflation.

Note: The first draft of this paper appeared under the title "Looking Behind the UK Term Structure: Were there Peso Problems in Inflation?"

JEL Classification: G12, E42, E31, E42