Finance Working Papers,
University of Aarhus, Aarhus School of Business, Department of Business Studies

Abstract: The paper investigates the effect of interest-rate variance on the shape of the

yield curve using a bivariate 2-state Markov switching model for the short-rate changes

and the yield curve slope. The two states are characterized by the variance of the shortrate

changes: Low and high variance. In the high variance regime the yield curve becomes

steeper with the interest-rate variance, in the low variance regime the slope is independent

hereof. A non-switching specification amounts to averaging across the two states. The

economy is in the high variance state during unusual economic periods.

Keywords: Interest-rate variance; Regime switching; SWARCH; Yield curve; Yield curve slope

31 pages, May 9, 2002

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