Alternative characterization of volatility of short-term interest rate

Ramaprasad Bhar and Damien Lee ()
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Ramaprasad Bhar: School of Risk and Actuarial Studies, The University of New South Wales, Sydney 2052, Australia
Damien Lee: School of Banking and Finance, The University of New South Wales, Sydney 2052, Australia

International Journal of Financial Engineering (IJFE), 2018, vol. 05, issue 02, 1-15

Abstract: Most reported stochastic volatility (SV) model for interest rates only deals with an AR specification for the latent factor process. We show in this paper the technical details for specifying the SV model for interest rates that includes an ARMA structure, a jump component and additional exogenous variables for the latent factor process. We demonstrate the efficacy of this approach with an application to the US short-term interest rate data. We find that the elasticity parameter of the variance is closer to 0.5, i.e., similar to that of the Cox–Ingersoll–Ross (1985) model of interest rates. This is quite a contrast to the finding Chan et al. [Chan, KC, GA Karolyi, F Longstaff and A Sanders (1992). The volatility of short-term interest rates: An empirical comparison of alternative models of term structure of interest rates, Journal of Finance, 47, 1209–1227]. who found the elasticity to be close to 1.5.

Keywords: Stochastic volatility; jump component; elasticity of variance; interest rate models (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1142/S2424786318500184

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