A short-term interest rate model with nonlinear mean reversion

Abstract

Interest rate models in the literature have assumed that the drift corresponds to a linear autoregressive process or constant. However, the question of whether or not the drift is actually linear has been considered in recent years. Regarding the fact that mean reversion of the interest rate process is an important feature making models complex, this paper introduces a new parameterized nonlinear short rate model, the exponential drift model, which is potentially applicable to describing the mean reversion property of financial processes. Both the new model and popular linear drift models (Chan et al., 1992) are compared through empirical analysis of the Japanese LIBOR rates. The result shows evidence of linear drift in the short term rates.