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 both mean reversion and conditional heteroskedasticity and nests the popular generalized autoregressive conditional heteroskedasticity (GARCH) and square root process specifications. The conditional variance process 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 GRS 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.