Comparison of the Short Term Interest Rate Models: Parametric Versus Non Parametric Approach

12 Pages Posted: 11 Feb 2014 Last revised: 21 Feb 2014

See all articles by Mona Ben Salah

Mona Ben Salah

University of Sfax - Faculty of Economics and Management (FSEGS)

Date Written: February 3, 2010

Abstract

This article attempts to identify the best model of the short term interest rates that can predict its stochastic process over time. We studied nine different models of the short term interest rates. The choice of these models was the aim of analyzing the relevance of certain specifications of the the short term interest rate stochastic process, the effect of mean reversion and the sensitivity of the volatility to the level of interest rate.

The yield on US three months treasury bills is used as a proxy for the short term interest rates. The parameters of the different stochastic process are estimated using the generalized method of moments. The results show that the effect of mean reversion is not statistically significant and that volatility is highly sensitive to the level of interest rates. To further study the performance prediction of the intertemporal behavior of the short term interest rate of the various models; we simulated their stochastic process for different periods.

The results show that none of the studied models reproduce the actual path of the short term interest rates. The problem lies in the parametric specification of the mean and volatility of the diffusion process To further study the accurate parametric specification of the interest rate stochastic process we use a nonparametric estimation of the drift and the diffusion functions. The results prove that both should be nonlinear.

Keywords: short term interest rate, diffusion process, GMM, Monte Carlo simulation, nonparametric estimation

JEL Classification: E43, E47, E37

Suggested Citation

Ben Salah, Mona, Comparison of the Short Term Interest Rate Models: Parametric Versus Non Parametric Approach (February 3, 2010). Available at SSRN: https://ssrn.com/abstract=2393909 or http://dx.doi.org/10.2139/ssrn.2393909

Mona Ben Salah (Contact Author)

University of Sfax - Faculty of Economics and Management (FSEGS) ( email )

Road of Airport, Km 4
Sfax, sfax 3018
Tunisia

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