On Model Selection and Markov Switching: A Empirical Examination of Term Structure Models with Regime Shifts

We examine several continuous-time term-structure models, in which the short rate is subject to discrete shifts. Our empirical analysis suggests that inquiring which parameters of the short-term interest rate equation are allowed to switch is crucial, as failing to do so may result in switching pricing models that produce no improvement (in terms of pricing) with respect to models which do not allow for regime switching, even when there are clear breaks in the data.