MODELING THE CONDITIONAL DISTRIBUTION OF INTEREST-RATES AS A REGIME-SWITCHING PROCESS

This paper develops a generalized regime-switching (GRS) model of the short-term interest rate. The model allows the short rate to exhibit b oth mean reversion and conditional heteroskedasticity and nests the po pular generalized autoregressive conditional heteroskedasticity (GARCH ) and square root process specifications. The conditional variance pro cess accommodates volatility clustering and dependence on the level of the interest rate. A first-order Markov process with state-dependent transition probabilities governs the switching between regimes. The GR S model is compared with various existing models of the short rate in terms of (1) the statistical fit of short-term interest rate data and (2) out-of-sample forecasting performance.