Is the Short Rate Drift Actually Nonlinear?

Chapman, David A.; Pearson, Neil D.

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https://hdl.handle.net/2142/4049

Description

Title

Is the Short Rate Drift Actually Nonlinear?

Author(s)

Chapman, David A.
Pearson, Neil D.

Issue Date

1998-06-16

Keyword(s)

nonparametric estimation
GMM estimation procedure
Stanton
Ait-Sahalia

Abstract

Virtually all existing continuous-time, single-factor term structure models are based on a short rate process that has a linear drift function. However, there is no strong a priori argument in favor of linearity, and Stanton (1997) and Ait-Sahalia (1996) employ nonparametric estimation techniques to conclude that the drift function of the short rate contains important nonlinearities. Comparatively little is known about the finite-sample properties of these estimators, particularly when they are applied to frequent sampling of a very persistent process, like short term interest rates. In this paper, we apply these estimators to simulated sample paths of a square-root diffusion. Although the drift function is linear, both estimators suggest nonlinearities of the type and magnitude reported in by Stanton (1997) and Ait-Sahalia (1996). These results, along with the results of a simple GMM estimation procedure applied to the Stanton and Ait-Sahalia data sets, imply that nonlinearity of the short rate drift is not a robust stylized fact.

Publisher

Office for Futures and Options Research, Department of Agricultural Economics, College of Agricultural, Consumer, and Environmental Sciences at the University of Illinois at Urbana-Champaign

Series/Report Name or Number

OFOR Working Paper Series, no. 98-07

Type of Resource

text

Language

en

Permalink

http://hdl.handle.net/2142/4049

Owning Collections

OFOR Working Paper Series PRIMARY