Modeling the stochastic behavior of short-term interest rates: Pricing implications for discount bonds

Abstract

This paper models the stochastic behavior of short-term interest rates, and determines the correct specification of the drift and diffusion functions of the spot rate process. A wide variety of one-factor diffusion and two-factor stochastic volatility models is compared in terms of their ability to capture the dynamics of interest rate volatility. The empirical evidence on the one-, three- and six-month Eurodollar deposit rates indicates that a new class of models with stochastic volatility is better than the single-factor diffusion models in forecasting the future volatility of interest rate changes. The paper extends the one-factor BDT term structure model to a two-factor setting, and presents the pricing implications for discount bonds. Monte Carlo simulation results for the implied yields of three- and six-month zero-coupon bonds imply that incorporating the so-called level and GARCH effects in volatility improves the pricing performance of the interest rate models.