Is the Short Rate Drift Actually Nonlinear?

45 Pages Posted: 30 Nov 1998

See all articles by David A. Chapman

David A. Chapman

McIntire School, University of Virginia

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: October 26, 1998

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), employing nonparametric estimation techniques, conclude that the drift function 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. 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 weighted least squares 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.

JEL Classification: G12, E43, C14

Suggested Citation

Chapman, David A. and Pearson, Neil D., Is the Short Rate Drift Actually Nonlinear? (October 26, 1998). Available at SSRN: https://ssrn.com/abstract=140055 or http://dx.doi.org/10.2139/ssrn.140055

David A. Chapman (Contact Author)

McIntire School, University of Virginia ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States

HOME PAGE: http://https://sites.google.com/site/davidchapmanswebsite/

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
217-244-0490 (Phone)
217-244-9867 (Fax)