Testing Models of the Spot Interest Rate Volatility

Abstract:     
This paper estimates discrete-time stochastic volatility models of the short-term spot interest rate for Germany and France, 1981-1997. Stochastic volatility interest rate models with both news and square root level effects seem to dominate alternative specifications. We extend previous results by using an exponential functional form for volatility, which is able to mitigate the impact of very large realizations and yield a better fit. Interest rate volatility shows a less persistent behavior than in stock returns and US Treasury bill yields volatility. Positive innovations in interest rates have a greater impact on conditional volatility than negative innovations.

Keywords: Interest rates, Stochastic volatility, GARCH

JEL Classification: C52, G12, E43

working papers series