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Using Proxies for the Short Rate: When are Three Months Like an Instant?

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Author Info
David A. Chapman (The University of Texas at Austin)
John B. Long Jr. (University of Rochester)
Neil D. Pearson (University of Illinois at Urbana-Champaign)

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Abstract

The dynamics of the unobservable "short" or "instantaneous" rate of interest are frequently estimated using a proxy variable. We show the biases resulting from this practice (the "proxy" problem) are related to the derivatives of the proxy with respect to the short rate and the (inverse) function from the proxy to the short rate. Analytic results show that the proxy problem is not economically significant for single- factor affine models, for parameter values consistent with US data. In addition, for the two-factor affine model of Longstaff and Schwartz (1992), the proxy problem is only economically significant for pricing discount bonds with maturities of more than 5 years. We also describe two different procedures which can be used to assess the magnitude of the proxy problem in more general interest rate models. Numerical evaluation of a nonlinear single-factor model suggests that the proxy problem can significantly affect both estimates of the diffusion function and discount bond prices.

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Paper provided by EconWPA in its series Finance with number 9808004.

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Date of creation: 28 Aug 1998
Date of revision: 07 Oct 1998
Handle: RePEc:wpa:wuwpfi:9808004

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Web page: http://129.3.20.41

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Related research
Keywords: interest rates; proxies; term structure;

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G1 - Financial Economics - - General Financial Markets

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  1. Driffill, John & Kenc, Turalay & Sola, Martin & Spagnolo, Fabio, 2004. "On Model Selection and Markov Switching: A Empirical Examination of Term Structure Models with Regime Shifts," CEPR Discussion Papers 4165, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  2. Andrew Jeffrey & Oliver Linton & Thong Nguyen, 2006. "Flexible Term Structure Estimation: Which Method is Preferred?," Metrika, Springer, vol. 63(1), pages 99-122, February. [Downloadable!] (restricted)
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  3. Hideyuki Takamizawa, 2007. "A Simple Measure for Examining the Proxy Problem of the Short-Rate," Asia-Pacific Financial Markets, Springer, vol. 14(4), pages 341-361, December. [Downloadable!] (restricted)
  4. Hao Zhou, 2001. "Jump-diffusion term structure and Ito conditional moment generator," Finance and Economics Discussion Series 2001-28, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  5. Jun Liu & Francis A. Longstaff & Ravit E. Mandell, 2002. "The Market Price of Credit Risk: An Empirical Analysis of Interest Rate Swap Spreads," NBER Working Papers 8990, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Thuy-Duong To, 2004. "A Note on the Bias of using Futures Rates as a Proxy for the Instantaneous Forward Rate," Research Paper Series 149, Quantitative Finance Research Centre, University of Technology, Sydney. [Downloadable!]
  8. Roberto Reno', 2004. "Nonparametric Estimation of the Diffusion Coefficient via Fourier Analysis, with Aplication to Short Rate Modeling," Department of Economics University of Siena 440, Department of Economics, University of Siena. [Downloadable!]
  9. Ram Bhar & Carl Chiarella & Wolfgang Runggaldier, 2001. "Estimation in Models of the Instantaneous Short Term Interest Rate By Use of a Dynamic Bayesian Algorithm," Research Paper Series 68, Quantitative Finance Research Centre, University of Technology, Sydney. [Downloadable!]
  10. Carl Chiarella & Sara Pasquali & Wolfgang Runggaldier, 2001. "On Filtering in Markovian Term Structure Models (An Approximation Approach)," Research Paper Series 65, Quantitative Finance Research Centre, University of Technology, Sydney. [Downloadable!]
  11. J. Benson Durham, 2005. "Jump-diffusion processes and affine term structure models: additional closed-form approximate solutions, distributional assumptions for jumps, and parameter estimates," Finance and Economics Discussion Series 2005-53, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  12. Torben G. Andersen & Luca Benzoni, 2007. "Do Bonds Span Volatility Risk in the U.S. Treasury Market? A Specification Test for Affine Term Structure Models," CREATES Research Papers 2007-25, School of Economics and Management, University of Aarhus. [Downloadable!]
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  13. A. Mele, 2000. "Fundamental Properties of Bond Prices in Models of the Short-Term Rate," THEMA Working Papers 2000-39, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise. [Downloadable!]
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  14. Ram Bhar & Carl Chiarella & Hing Hung & Wolfgang Runggaldier, 2004. "The Volatility of the Instantaneous Spot Interest Rate Implied by Arbitrage Pricing - A Dynamic Bayesian Approach," Finance 0409002, EconWPA. [Downloadable!]
  15. Jin-Chuan Duan & Kris Jacobs, 2001. "Short and Long Memory in Equilibrium Interest Rate Dynamics," CIRANO Working Papers 2001s-22, CIRANO. [Downloadable!]
  16. Ram Bhar & Carl Chiarella & Thuy Duong To, 2002. "A Maximum Likelihood Approach to Estimation of Heath-Jarrow-Morton Models," Research Paper Series 80, Quantitative Finance Research Centre, University of Technology, Sydney. [Downloadable!]
  17. Czellar, Veronika & Karolyi, G. Andrew & Ronchetti, Elvezio, 2005. "Indirect Robust Estimation of the Short-term Interest Rate Process," Working Paper Series 2005-4, Ohio State University, Charles A. Dice Center for Research in Financial Economics. [Downloadable!]
  18. Veronika Czellar & G. Andrew Karolyi & Elvezio Ronchetti, 2005. "Indirect Robust Estimation of the Short-term Interest Rate Process;," Cahiers du Département d'Econométrie 2005.02, Département d'Econométrie, Université de Genève. [Downloadable!]
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  19. Ram Bhar & Carl Chiarella & Thuy-Duong To, 2004. "Estimating the Volatility Structure of an Arbitrage-Free Interest Rate Model Via the Futures Markets," Finance 0409003, EconWPA. [Downloadable!]
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