Stochastic Volatility or Stochastic Central Tendency: Evidence from a Hidden Markov Model of the Short-Term Interest Rate

Craig A. Wilson () and Robert J. Elliott ()
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Craig A. Wilson: University of Saskatchewan
Robert J. Elliott: University of Calgary

Chapter Chapter 2 in Hidden Markov Models in Finance, 2014, pp 33-53 from Springer

Abstract: Abstract We develop a two-factor model for the short-term interest rate that incorporates additional randomness in both the drift and diffusion components. In particular, the model nests stochastic volatility and stochastic central tendency, and therefore provides a medium for testing the overall importance of both factors. The randomness in the drift and diffusion terms is governed by a hidden Markov chain. The likelihood function is determined through an iterative procedure and maximum likelihood estimates are obtained via numerical maximization. This process allows likelihood ratio testing of nested restrictions. These tests show that stochastic volatility is more important than stochastic central tendency for describing the short rate dynamics.

Keywords: Interest Rate; Markov Chain; Central Tendency; Term Structure; Stochastic Volatility (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1007/978-1-4899-7442-6_2

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