Yield Curve Models with Regime Changes: An Analysis for the Brazilian Interest Rate Market

This study examines the effectiveness of various specifications of the dynamic Nelson–Siegel term structure model in analyzing the term structure of Brazilian interbank deposits. A key contribution of our research is the incorporation of regime changes and other time-varying parameters in the model, both when relying solely on observed yields and when incorporating macroeconomic variables. By allowing parameters in the latent factors to adapt to changes in persistence patterns and the overall shape of the yield curve, these mechanisms enhance the model’s flexibility. To evaluate the performance of the models, we conducted assessments based on their in-sample fit and out-of-sample forecast accuracy. Our estimation approach involved Bayesian procedures utilizing Markov Chain Monte Carlo techniques. The results highlight that models incorporating macro factors and greater flexibility demonstrated superior in-sample fit compared to other models. However, when it came to out-of-sample forecasts, the performance of the models was influenced by the forecast horizon and maturity. Models incorporating regime switching exhibited better performance overall. Notably, for long maturities with a one-month ahead forecast horizon, the model incorporating regime changes in both the latent and macro factors emerged as the top performer. On the other hand, for a twelve-month horizon, the model incorporating regime switching solely in the macro factors demonstrated superior performance across most maturities. These findings have significant implications for the development of trading and hedging strategies in interest rate derivative instruments, particularly in emerging markets that are more prone to regime changes and structural breaks.