Estimating Continuous-Time Stochastic Volatility Models of the Short-Term Interest Rate: A Comparison of the Generalized Method of Moments and the Kalman Filter
43 Pages Posted: 3 Sep 2009
Date Written: September 2, 2009
Abstract
This paper examines a model of short-term interest rates that incorporates stochastic volatility as an independent latent factor into the popular continuous-time mean-reverting model of Chan et al. (1992). I demonstrate that this two-factor specification can be efficiently estimated within a generalized method of moments (GMM) framework using a judicious choice of moment conditions. The GMM procedure is compared to a Kalman filter estimation approach. Empirical estimation is implemented on US Treasury bill yields using both techniques. A Monte Carlo study of the finite sample performance of the estimators shows that GMM produces more heavily biased estimates than does the Kalman filter, and with generally larger mean squared errors.
Keywords: Stochastic volatility, short interest rate, generalized method of moments, GMM, Kalman filter, quasi-maximum likelihood
JEL Classification: G12, C51
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