Are There Nonlinearities in Short-Term Interest Rates?

19 Pages Posted: 8 May 2006

See all articles by Sirimon Treepongkaruna

Sirimon Treepongkaruna

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

Stephen Gray

University of Queensland - Business School; Duke University - Fuqua School of Business; Financial Research Network (FIRN)

Abstract

The present paper investigates the characteristics of short-term interest rates in several countries. We examine the importance of nonlinearities in the mean reversion and volatility of short-term interest rates. We examine various models that allow the conditional mean (drift) and conditional variance (diffusion) to be functions of the current short rate. We find that different markets require different models. In particular, we find evidence of nonlinear mean reversion in some of the countries that we examine, linear mean reversion in others and no mean reversion in some countries. For all countries we examine, there is strong evidence of the need for the volatility of interest rate changes to be highly sensitive to the level of the short-term interest rate. Out-of-sample forecasting performance of one-factor short rate models is poor, stemming from the inability of the models to accommodate jumps and discontinuities in the time series data.

Suggested Citation

Treepongkaruna, Sirimon and Gray, Stephen, Are There Nonlinearities in Short-Term Interest Rates?. Accounting and Finance, Vol. 46, No. 1, pp. 149-167, March 2006. Available at SSRN: https://ssrn.com/abstract=889781 or http://dx.doi.org/10.1111/j.1467-629X.2006.00151.x

Sirimon Treepongkaruna (Contact Author)

The University of Western Australia ( email )

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Financial Research Network (FIRN)

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Australia

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Stephen Gray

University of Queensland - Business School ( email )

University of Queensland
Brisbane, Queensland 4072
Australia

Duke University - Fuqua School of Business

Box 90120
Durham, NC 27708-0120
United States

Financial Research Network (FIRN) ( email )

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

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