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Regime Switching Term Structure Model Under Partial Information

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  • HIDENORI FUTAMI

    (Tokio Marine & Nichido Fire Insurance Co., Ltd., Tokio Marine Nichido Building Honkan, 1-2-1, Marunouchi, Chiyoda-ku, Tokyo, 100-8050, Japan)

Abstract

In this study, we attempt to calculate the term structure of the interest rate under partial information using a model in which the mean reversion level of the short rate changes in accordance with a regime shift in the economy. Under partial information, an investor observes the history of only the short rate and not a regime shift; hence, calculating the term structure of the interest rate is reduced to the problem of filtering the current regime from observable short rates. Therefore, we calculate it using the filtering theory that estimates a stochastic process from noisy observations, and investigate the effects of the regime shift under partial information on the market price of risk and the volatility of a bond price compared with those under full information, in which the regime is assumed to be observable. We find that, under partial information, the regime-shift risk converts into the diffusion risk. As a result, we find that both the market price of diffusion risk and the volatility of a bond price under partial information become stochastic, even though these under full information are constant.

Suggested Citation

  • Hidenori Futami, 2011. "Regime Switching Term Structure Model Under Partial Information," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 14(02), pages 265-294.
    • Handle: RePEc:wsi:ijtafx:v:14:y:2011:i:02:n:s0219024911006358
    DOI: 10.1142/S0219024911006358
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    References listed on IDEAS

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    1. Pietro Veronesi & Francis Yared, 1999. "Short and Long Horizon Term and Inflation Risk Premia in the US Term Structure: Evidence from an Integrated Model for Nominal and Real Bond Prices under Regime Shifts," CRSP working papers 508, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    2. Kohei Marumo & Takashi Nakayama & Shinichi Nishioka & Toshihiro Yoshida, 2003. "Extracting Market Expectations on the Duration of the Zero Interest Rate Policy from Japan's Bond Prices," Bank of Japan Working Paper Series Financial Markets Departm, Bank of Japan.
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