The Dynamics of Short-Term Interest Rate Volatility Reconsidered

Abstract

In this paper we present and estimate a model of short-term interest rate volatility that encompasses both the level effect of Chan, Karolyi, Longstaff and Sanders (1992) and the conditional heteroskedasticity effect of the GARCH class of models. This flexible specification allows different effects to dominate as the level of the interest rate varies. We also investigate implications for the pricing of bond options. Our findings indicate that the inclusion of a volatility effect reduces the estimate of the level effect, and has option implications that differ significantly from the Chan, Karolyi, Longstaff and Sanders (1992) model. Chan, Karolyi, Longstaff and Sanders (1992, CKLS) compare a number of widely used continuous-time models of the short-term interest rate. They estimate various models and compare the models in terms of their ability to capture the actual behavior of the short-term riskless rate. issue of how these models compare is important because the models differ in their implications for valuing contingent claims and hedging interest rate risk. 1 testing approach of CKLS exploits the fact that many term structure models imply dynamics for the short-term riskless rate that can be nested in one stochastic differential equation. With respect to the most successful models they conclude: The results for the tests of the one-month Treasury Bill indicate that it is critical to model volatility correctly. models that best describe the dynamics of the interest rates over time are those that allow the conditiorial volatility of interest rate changes to be highly dependent on the