Is the Short Rate Drift Actually Nonlinear?


  • David A. Chapman,

  • Neil D. Pearson

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    • Chapman is from the University of Texas at Austin and Pearson is from the University of Illinois at Urbana-Champaign. We thank Yacine Aït-Sahalia, Jonathan Berk, Murray Carlson, John Cochrane, Andy Filardo, Eric Hughson, Narasimhan Jegadeesh, Chris Jones, George Pennachi, René Stulz (the editor), Robert Whitelaw, an anonymous referee, seminar participants at the University of Illinois at Urbana-Champaign, the University of Texas at Austin, the University of Utah, and the “Asset Pricing” session of the 1998 NBER Summer Institute, and in particular, Matt Pritsker for helpful comments and discussions.


Aït-Sahalia (1996) and Stanton (1997) use nonparametric estimators applied to short-term interest rate data to conclude that the drift function contains important nonlinearities. We study the finite-sample properties of their estimators by applying them 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 Aït-Sahalia (1996) and Stanton (1997). Combined with the results of a weighted least squares estimator, this evidence implies that nonlinearity of the short rate drift is not a robust stylized fact.