Modelling Conditional Heteroscedasticity and Jumps in Australian Short-Term Interest Rates

15 Pages Posted: 3 Feb 2006

See all articles by Kam Fong Chan

Kam Fong Chan

The University of Western Australia; Financial Research Network (FIRN)

Abstract

The present paper explores a class of jump-diffusion models for the Australian short-term interest rate. The proposed general model incorporates linear mean-reverting drift, time-varying volatility in the form of LEVELS (sensitivity of the volatility to the levels of the short-rates) and generalized autoregressive conditional heteroscedasticity (GARCH), as well as jumps, to match the salient features of the short-rate dynamics. Maximum likelihood estimation reveals that pure diffusion models that ignore the jump factor are mis-specified in the sense that they imply a spuriously high speed of mean-reversion in the level of short-rate changes as well as a spuriously high degree of persistence in volatility. Once the jump factor is incorporated, the jump models that can also capture the GARCH-induced volatility produce reasonable estimates of the speed of mean reversion. The introduction of the jump factor also yields reasonable estimates of the GARCH parameters. Overall, the LEVELS-GARCH-JUMP model fits the data best.

Keywords: Short-rate, Jump-diffusion, LEVELS effect, generalized autoregressive conditional heteroscedasticity

JEL Classification: C13, C52, E43, G12

Suggested Citation

Chan, Kam Fong, Modelling Conditional Heteroscedasticity and Jumps in Australian Short-Term Interest Rates. Accounting and Finance, Vol. 45, No. 4, pp. 537-551, December 2005. Available at SSRN: https://ssrn.com/abstract=867116 or http://dx.doi.org/10.1111/j.1467-629X.2005.00153.x

Kam Fong Chan (Contact Author)

The University of Western Australia ( email )

35 Stirling Highway
Crawley, Western Australia 6009
Australia

Financial Research Network (FIRN) ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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