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Nonparametric Estimation of the Short Rate Diffusion Process from a Panel of Yields

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  • Sam, Abdoul G.
  • Jiang, George J.

Abstract

In this paper, we propose a nonparametric estimator of the short rate diffusion process using observations of a panel of yields. The proposed estimator can greatly reduce the bias of the nonparametric estimator proposed in Stanton (1997) that uses a single time series of short rate observations. Simulations confirm that the new method significantly attenuates the spurious nonlinearity of the drift function as documented in Chapman and Pearson (2000). We apply the method to estimate the U.S. short rate process using a panel of six Treasury yields. With 42 years’ daily observations of the panel of yields, the proposed drift function estimator achieves the same efficiency as the Stanton (1997) estimator based on 145 years of daily short rate observations. Finally, we show that the proposed estimator also has significant economic implications on the pricing of bonds and interest rate derivatives.

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  • Sam, Abdoul G. & Jiang, George J., 2009. "Nonparametric Estimation of the Short Rate Diffusion Process from a Panel of Yields," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(05), pages 1197-1230, October.
  • Handle: RePEc:cup:jfinqa:v:44:y:2009:i:05:p:1197-1230_99
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    Cited by:

    1. Francesco Audrino, 2012. "What Drives Short Rate Dynamics? A Functional Gradient Descent Approach," Computational Economics, Springer;Society for Computational Economics, vol. 39(3), pages 315-335, March.
    2. Abdoul G. Sam, 2010. "Nonparametric estimation of market risk: an application to agricultural commodity futures," Agricultural Finance Review, Emerald Group Publishing, vol. 70(2), pages 285-297, August.
    3. Chen, Qiang & Zheng, Xu & Pan, Zhiyuan, 2015. "Asymptotically distribution-free tests for the volatility function of a diffusion," Journal of Econometrics, Elsevier, vol. 184(1), pages 124-144.
    4. Song, Zhaogang, 2011. "A martingale approach for testing diffusion models based on infinitesimal operator," Journal of Econometrics, Elsevier, vol. 162(2), pages 189-212, June.

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