Drift and Diffusion Function Specification for Short-Term Interest Rates

• Main Authors: LEE, Myoung-jae, LI, Wen Juan
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2005
• Subjects: Short rate; Diffusion; Spatial correlation; Econometrics
• Online Access: https://ink.library.smu.edu.sg/soe_research/177; https://ink.library.smu.edu.sg/context/soe_research/article/1176/viewcontent/DriftDiffusionFunction_Specification_2005.pdf
• Institution: Singapore Management University

Various stochastic differential equation models for short rates (rt) have been proposed, where the change (Δrt = rt−rt−1) is modeled as a sum of drift and diffusion terms depending on rt−1. These models, however, have some shortcomings. First, the same model may not apply to all countries. Second, the drift and diffusion may depend not only on rt−1 but also on further lags. Third, not just the own lagged rates, but also other countries' rates may matter. These questions are empirically analyzed for six major countries with the following findings. First, there are considerable differences in drift and diffusion across the countries. Second, the drift and diffusion often depend on rt−2 (and rt−3). Third, foreign rates exert substantial effects.