An Empirical Comparison of the Short Term Interest Rate Models
11 Pages Posted: 25 Feb 2014
Date Written: January 20, 2012
This article attempts to identify the best model of the short term interest rates that can predict its stochastic process over time.
We studied eight different models of interest rates in the short term. The choice of these models was the aim of analyzing the relevance of certain specifications of the stochastic process of the short term interest rates, the effect of mean reversion and the sensitivity of the volatility to the level of interest rate.
The yield on 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.
Keywords: short term interest rate, diffusion process, GMM, Monte Carlo simulation
JEL Classification: E43, E47
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