A Nonparametric Model of Term Structure Dynamics and the Market Price of Interest Rate Risk



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    • Haas School of Business, University of California, Berkeley. For helpful comments and suggestions I thank Gurdip Bakshi, Pierluigi Balduzzi, Steve Grenadier, Dilip Madan, Matthew Richardson, René Stulz, an anonymous referee, seminar participants at Berkeley, Harvard, MIT, Michigan, NYU, LBS, Long Term Capital Management, Stanford, UCLA, University of California, Irvine, the 1996 Utah Winter Finance Conference, the 1996 meetings of the Western Finance Association, and the Society for Economic Dynamics and Control, and the 1997 meetings of the American Finance Association. I am grateful for financial assistance from the Berkeley Program in Finance, the U.C. Berkeley Committee on Research, and the Fisher Center for Real Estate and Urban Economics.


This article presents a technique for nonparametrically estimating continuous-time diffusion processes that are observed at discrete intervals. We illustrate the methodology by using daily three and six month Treasury Bill data, from January 1965 to July 1995, to estimate the drift and diffusion of the short rate, and the market price of interest rate risk. While the estimated diffusion is similar to that estimated by Chan, Karolyi, Longstaff, and Sanders (1992), there is evidence of substantial nonlinearity in the drift. This is close to zero for low and medium interest rates, but mean reversion increases sharply at higher interest rates.