Are there nonlinearities in short-term interest rates?

Authors: Treepongkaruna, Sirimon¹; Gray, Stephen²

Source: Accounting and Finance, Volume 46, Number 1, March 2006 , pp. 149-167(19)

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Abstract:

The present paper investigates the characteristics of short-term interest rates in several countries. We examine the importance of nonlinearities in the mean reversion and volatility of short-term interest rates. We examine various models that allow the conditional mean (drift) and conditional variance (diffusion) to be functions of the current short rate. We find that different markets require different models. In particular, we find evidence of nonlinear mean reversion in some of the countries that we examine, linear mean reversion in others and no mean reversion in some countries. For all countries we examine, there is strong evidence of the need for the volatility of interest rate changes to be highly sensitive to the level of the short-term interest rate. Out-of-sample forecasting performance of one-factor short rate models is poor, stemming from the inability of the models to accommodate jumps and discontinuities in the time series data.

Keywords: Short-term interest rates; Mean reversion; Conditional volatility; C52; E43; G15

Document Type: Research article

DOI: http://dx.doi.org/10.1111/j.1467-629X.2006.00151.x

Affiliations: 1: School of Finance and Applied Statistics, Australian National University, Canberra, 0200, Australia 2: UQ Business School, University of Queensland, Brisbane, 4072, Australia

Publication date: 2006-03-01