MODELING INTEREST-RATE VOLATILITY - REGIME SWITCHES AND LEVEL LINKS

This paper presents a model encompassing the Markov switching model an d the model based on a volatility-level link. This encompassing model allows to test these competing classes of volatility models against ea ch other. If is found that both classes capture essential but differen t features of the interest rate volatility process. A volatility model incorporating both features, i.e., regime switches and level links, c learly outperforms both alternatives. The consequences of this finding , both for volatility prediction and for the selection of the more app ropriate theoretical (continuous time) interest rate model, are discus sed.