An Empirical Comparison of Alternative Models of the Short-Term Interest Rate


  • K. C. CHAN,




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    • All authors are from the College of Business, The Ohio State University. We are grateful for the comments and suggestions of Warren Bailey, Emilio Barone, Fischer Black, Tim Bollerslev, Stephen Buser, John Campbell, Jennifer Conrad, George Constantinides, Ken Dunn, Margaret Forster, Campbell Harvey, Patric Hendershott, David Mayers, Huston McCulloch, Daniel Nelson, David Shimko, René Stulz, Stuart Turnbull, Curt Wells, and Finance Workshop participants at the Commodity Futures Trading Commission, the University of Iowa, the Kansallis Research Foundation, The Ohio State University, Purdue University, and participants at the 1991 Western Finance Association meetings, the 1991 European Finance Association meetings, the 1992 American Finance Association meetings, and the 1992 Federal Reserve Bank of Atlanta's Conference on Financial Market Issues. All errors are our responsibility.


We estimate and compare a variety of continuous-time models of the short-term riskless rate using the Generalized Method of Moments. We find that the most successful models in capturing the dynamics of the short-term interest rate are those that allow the volatility of interest rate changes to be highly sensitive to the level of the riskless rate. A number of well-known models perform poorly in the comparisons because of their implicit restrictions on term structure volatility. We show that these results have important implications for the use of different term structure models in valuing interest rate contingent claims and in hedging interest rate risk.