The Stability of Interest Rate Processes

Working Paper Number 97-13

23 Pages Posted: 23 Feb 1998

See all articles by Robert R. Bliss

Robert R. Bliss

Wake Forest University - Schools of Business

David C. Smith

University of Virginia - McIntire School of Commerce

Date Written: November 1997

Abstract

This paper argues that model selection and parameter stability are closely linked. We show this tie in a careful reexamination of Chan, Karolyi, Longstaff, and Sanders (1992). The widely cited conclusion of their paper was that g = 1.5. This result depends crucially on a misspecification of the period during which the interest rate process changed in response to a temporary change in how the Federal Reserve implemented monetary policy. Defining the structural shift as coincident with this policy shift, we find that there is strong evidence in the interest rate data of a structural break. This result is robust both to changes in short-rate series and to the most egregious outlier. Furthermore, we find evidence that, contrary to CKLS' claim, a moderate-g interest rate process can capture the dependence of volatility on the level of interest rates while high-g models cannot. This result is reasonably robust to changes in the short rate used and the treatment of outliers. In particular, this study finds support for the square-root CIR process, at least amongst the class of single-factor diffusion process. There is no support for constant volatility models in either CKLS or this study.

JEL Classification: E40, C52

Suggested Citation

Bliss, Robert R. and Smith, David Carl, The Stability of Interest Rate Processes (November 1997). Working Paper Number 97-13. Available at SSRN: https://ssrn.com/abstract=61446 or http://dx.doi.org/10.2139/ssrn.61446

Robert R. Bliss (Contact Author)

Wake Forest University - Schools of Business ( email )

P.O. Box 7659
Winston-Salem, NC 27109-7285
United States

David Carl Smith

University of Virginia - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States

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