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Asymmetric Mean Reversion in European Interest Rates: A Two-factor Model

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  • Gregory Koutmos
  • George Philippatos

Abstract

This paper tests for asymmetric mean reversion in European short-term interest rates using a combination of the interest rate models introduced by Longstaff and Schwartz (Longstaff, F.A., Schwarts, E.S. (1992) Interest rate volatility and the ferm structure: A two factor general equilibrium model, Journal of Finance, 48, pp. 1259-1282.) and Bali (Bali, T. (2000) Testing the empirical performance of stochastic volatility models of the short-term interest rates, Journal of Financial and Quantitative Analysis, 35, pp. 191-215.). Using weekly rates for France, Germany and the United Kingdom, it is found that short-term rates follow in all instances asymmetric mean reverting processes. Specifically, interest rates exhibit non-stationary behavior following rate increases, but they are strongly mean reverting following rate decreases. The mean reverting component is statistically and economically stronger thus offsetting non-stationarity. Volatility depends on past innovations past volatility and the level of interest rates. With respect to past innovations volatility is asymmetric rising more in response to positive innovations. This is exactly opposite to the asymmetry found in stock returns.

Suggested Citation

  • Gregory Koutmos & George Philippatos, 2007. "Asymmetric Mean Reversion in European Interest Rates: A Two-factor Model," The European Journal of Finance, Taylor & Francis Journals, vol. 13(8), pages 741-750.
    • Handle: RePEc:taf:eurjfi:v:13:y:2007:i:8:p:741-750
    DOI: 10.1080/13518470701705728
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    References listed on IDEAS

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    3. Choudhry, Taufiq, 2016. "Time-varying risk premium yield spread effect in term structure and global financial crisis: Evidence from Europe," International Review of Financial Analysis, Elsevier, vol. 48(C), pages 303-311.
    4. Lee, Chien-Chiang & Lee, Cheng-Feng & Lee, Chi-Chuan, 2014. "Asymmetric dynamics in REIT prices: Further evidence based on quantile regression analysis," Economic Modelling, Elsevier, vol. 42(C), pages 29-37.

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