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The stability of interest rate processes

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  • Robert R. Bliss
  • David C. Smith
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    Abstract

    This paper presents a careful reexamination of Chan, Karolyi, Longstaff, and Sanders (CKLS 1992). By redefining the possible regime shift period in line with evidence from known policy changes and past empirical research, we find evidence that contradicts the major results in their paper. The widely cited conclusion of their paper is that the elasticity of interest rate volatility is 1.5. CKLS also concluded that there was no structural shift in the interest rate process after October 1979. When the structural shift period is defined to be temporary and coincident with the Federal Reserve Experiment of October 1979 through September 1982, we find that there is strong evidence of a structural break. Furthermore, we find evidence that, contrary to CKLS's claim, a moderately elastic interest rate process can capture the dependence of volatility on the level of interest rates, while highly elastic models cannot. In particular, this study finds support for the square-root CIR process. These results are robust to changes in the short-rate data used and the treatment of outliers.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 97-13.

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    Date of creation: 1997
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    Handle: RePEc:fip:fedawp:97-13

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    Keywords: Econometric models ; Interest rates ; Money;

    References

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    1. Dahlquist, Magnus, 1996. "On alternative interest rate processes," Journal of Banking & Finance, Elsevier, vol. 20(6), pages 1093-1119, July.
    2. Gregory R. Duffee, 1994. "Idiosyncratic variation of Treasury bill yields," Finance and Economics Discussion Series 94-28, Board of Governors of the Federal Reserve System (U.S.).
    3. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(2), pages 1-78.
    4. Newey, Whitney K & West, Kenneth D, 1987. "Hypothesis Testing with Efficient Method of Moments Estimation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 777-87, October.
    5. Yacine Ait-Sahalia, 1995. "Testing Continuous-Time Models of the Spot Interest Rate," NBER Working Papers 5346, National Bureau of Economic Research, Inc.
    6. Sanders, Anthony B. & Unal, Haluk, 1988. "On the Intertemporal Behavior of the Short-Term Rate of Interest," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(04), pages 417-423, December.
    7. Brenner, Robin J. & Harjes, Richard H. & Kroner, Kenneth F., 1996. "Another Look at Models of the Short-Term Interest Rate," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(01), pages 85-107, March.
    8. Huizinga, John & Mishkin, Frederic S, 1984. " Inflation and Real Interest Rates on Assets with Different Risk Characteristics," Journal of Finance, American Finance Association, vol. 39(3), pages 699-712, July.
    9. Hamilton, James D., 1988. "Rational-expectations econometric analysis of changes in regime : An investigation of the term structure of interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 385-423.
    10. John Y. Campbell, 1985. "Stock Returns and the Term Structure," NBER Working Papers 1626, National Bureau of Economic Research, Inc.
    11. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, vol. 47(3), pages 1209-27, July.
    12. Gray, Stephen F., 1996. "Modeling the conditional distribution of interest rates as a regime-switching process," Journal of Financial Economics, Elsevier, vol. 42(1), pages 27-62, September.
    13. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
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    Cited by:
    1. Francis X. Diebold & Lei Ji & Canlin Li, 2006. "A Three-Factor Yield Curve Model: Non-Affine Structure, Systematic Risk Sources, and Generalized Duration," PIER Working Paper Archive 06-017, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
    2. Robert R. Bliss, 1997. "Movements in the term structure of interest rates," Economic Review, Federal Reserve Bank of Atlanta, issue Q 4, pages 16-33.
    3. William Roberds & Charles H. Whiteman, 1996. "Endogenous term premia and anomalies in the term structure of interest rates: explaining the predictability smile," Working Paper 96-11, Federal Reserve Bank of Atlanta.
    4. Dennis Philip & Chihwa Kao & Giovanni Urga, 2007. "Testing for Instability in Factor Structure of Yield Curves," Center for Policy Research Working Papers 96, Center for Policy Research, Maxwell School, Syracuse University.
    5. Beliaeva, Natalia & Nawalkha, Sanjay, 2012. "Pricing American interest rate options under the jump-extended constant-elasticity-of-variance short rate models," Journal of Banking & Finance, Elsevier, vol. 36(1), pages 151-163.

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