Estimating the Term Premium by a Markov Switching Model with ARMA-GARCH Errors

Abstract

We estimate the term premium in the term structure of risk-free interest rates using a Markov switching model with ARMA-GARCH errors. We find that the Markov switching term premium is closely related to the U.S. business cycle and plays a significant role in explaining changes in short-term interest rates. The result is not affected even when we consider other macro variables or excess return forecasting factors. In order to estimate the Markov switching model with the non-Markovian structure, we propose a new Bayesian approach by which we do not need to approximate the likelihood function and we generate the state variable using a Gibbs sampler.