Markov-Switching and Stochastic Volatility Diffusion Models of Short-Term Interest Rates

This paper empirically compares the Markov-switching and stochastic volatility diffusion models of the short rate. The evidence supports the Markov-switching diffusion model. Estimates of the elasticity of volatility parameter for single regime models unanimously indicate an explosive volatility process, while the Markov-switching models estimates are reasonable. We find that either Markov-switching or stochastic volatility, but not both, are needed to adequately fit the data. A robust conclusion is that volatility depends on the level of the short rate. Finally, the Markov-switching model is the best in terms of forecasting. A technical contribution of this paper is a presentation of quasi-maximum likelihood estimation techniques for the Markov-switching stochastic-volatility model.