A regime-switching term structure model with observable state variables |
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| Authors: | René Ferland Geneviève Gauthier Simon Lalancette |
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| Institution: | 1. Department of Economics and Finance, Institute of Business Administration Karachi, Pakistan;2. Department of Accounting and Finance, Cookworthy building, Room 229-b, Plymouth Business School, Plymouth PL4 8AA, UK |
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| Abstract: | The paper proposes in a regime-shift framework, an arbitrage-free term structure model based on the target and Fed Funds Rates. Empirical observations suggest that a three-state regime-shift environment associated with FOMC monetary actions is justified. Then, a closed-form solution for zero-coupon bonds is derived where regime-shift risk is priced. The solution is flexible enough to incorporate additional state variables. |
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