Dynamic characteristics of expectations of short-term interest rate and a generalized Vasicek model

Abstract

This study's principal mathematical deduction exploits the importance of the specification of long-term equilibrium level in the mean-reversion short-term interest rate model—such as the CKLS (Chan, Karolyi, Longstaff, and Sanders) model—to describe the dynamic characteristics of future short-term interest rate expectations, especially long-horizon expectations. Therefore, we present a preferred model by introducing a stochastic long-run equilibrium level factor to extend the specifications of the Vasicek model's short-term interest rate dynamics. Using this new type of short-term interest rate as a driver we develop a two-factor affine arbitrage-free model of term structure, the generalized Vasicek mode. The empirical results show that the model not only has a good sample fitting ability to the Chinese government bond yield curve, but also has better performance in capturing the dynamic characteristics of short-term interest rates and short-term interest rate expectations. This study provides not only a promising avenue for future research on improving interest rate modeling techniques and their practical applications in the financial industry but also a new literature base for accurately identifying public expectations and explaining the underlying mechanisms of expectation changes.