The Dynamics of the Australian Short†Term Interest Rate

This paper examines various models of the short†term interest rate in Australia. The analysis centres on three classes of models. First, the generalised diffusion model of Chan et al. (1992) is examined which allows the variance to be a function of interest rate levels. This model nests a number of the traditional term structure models. We find initial support for the generalised model. Second, we examine models which incorporate time†varying volatility dynamics. Third, a class of models that incorporates both time†varying volatility and the levels model is analysed. We extend these models by allowing an asymmetric reaction to news resulting in a threshold†type model. The paper examines each of the models and then proposes and perfor Ms prediction tests that allow different classes of models to be benchmarked. The second and third class of models appear to produce the most accurate estimates. The results indicate a number of important differences between the Australian market and overseas markets.