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Testing the Empirical Performance of Stochastic Volatility Models of the Short-Term Interest Rate

Published online by Cambridge University Press:  06 April 2009

Turan G. Bali
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Abstract

I introduce two-factor discrete time stochastic volatility models of the short-term interest rate to compare the relative performance of existing and alternative empiricial specificattions. I develop a nonlinear asymmmetric framework that allows for comparisons of non-nested models featuring conditional heteoskedasticity and sensitivity of the volatility process to interest rate levels. A new class of stochastic volatility models with asymmetric GARCH models. The existing models are rejected in favor of the newly proposed models because of the asymmetric drift of the short rate, and the presence of nonlinearity, asymmetry, GARCH, and level effects in its volatility. I test the predictive power of nested and non-nested models in capturing the stochastic behavior of the risk-free rate. Empirical evidence on three-, six-, and 12-month U.S. Treasury bills indicates but that two-factor stochastic volatility models are better than diffusion and GARCH models in forecasting the future level and volatility of interest rate changes.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 35 , Issue 2 , June 2000 , pp. 191 - 215
Copyright
Copyright © School of Business Administration, University of Washington 2000

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Footnotes

*

Department of Economics and Finance, Baruch College, City University of New York, 17 Lexington Avenue, Box E-621, New York, NY 10010. I am very; grateful to paul Malatesta (the editor) and Vance Roley (associate editor and referee) for their extremely helpful comments and suggestions. Finacial Support from the PSC-CUNY Research Foundationa of the City University of New York is also gratefully acknowledged.

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