Nonparametric Estimation of the Short Rate Diffusion from a Panel of Yields

34 Pages Posted: 15 Mar 2006 Last revised: 20 Feb 2013

See all articles by Abdoul G. Sam

Abdoul G. Sam

The Ohio State University

George J. Jiang

Washington State University

Date Written: December 1, 2008

Abstract

In this paper, we propose a nonparametric estimator of the short rate diffusion process using observations of a panel of yields. The proposed estimator can greatly reduce the bias of the nonparametric estimator proposed in Stanton (1997) that uses a single time series of short rate observations. Simulations confirm that the new method significantly attenuates the spurious nonlinearity of the drift function as documented in Chapman and Pearson (2000). We apply the method to estimate the U.S. short rate process using a panel of six Treasury yields.With 42 years’ daily observations of the panel of yields, the proposed drift function estimator achieves the same efficiency as the Stanton (1997) estimator based on 145 years of daily short rate observations. Finally, we show that the proposed estimator also has significant economic implications on the pricing of bonds and interest rate derivatives.

Keywords: drift function, nonparametric estimation, panel of yields

Suggested Citation

Sam, Abdoul G. and Jiang, George, Nonparametric Estimation of the Short Rate Diffusion from a Panel of Yields (December 1, 2008). Journal of Financial and Quantitative Analysis (JFQA), Vol. 44, No. 5, 2009. Available at SSRN: https://ssrn.com/abstract=890982 or http://dx.doi.org/10.2139/ssrn.890982

Abdoul G. Sam (Contact Author)

The Ohio State University ( email )

238 AG. Administration Building
2120 Fyffe Road
Columbus, OH OH 43210
United States

HOME PAGE: http://aede.osu.edu/our-people/abdoul-sam

George Jiang

Washington State University ( email )

Department of Finance and Management Science
Carson College of Business
Pullman, WA 99-4746164
United States
509-3354474 (Phone)

HOME PAGE: http://directory.business.wsu.edu/bio.html?username=george.jiang

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