ANOTHER LOOK AT MODELS OF THE SHORT-TERM INTEREST-RATE

The short-term rate of interest is fundamental to much of theoretical and empirical finance, yet no consensus has emerged on the dynamics of its volatility. We show that models which parameterize volatility onl y as a function of interest rate levels tend to over emphasize the sen sitivity of volatility to levels and fail to model adequately the seri al correlation in conditional variances. On the other hand, serial cor relation based models like GARCH models fail to capture adequately the relationship between interest rate levels and volatility. We introduc e and test a new class of models for the dynamics of short-term intere st rate volatility, which allows volatility to depend on both interest rate levels and information shocks. Two important conclusions emerge. First, the sensitivity of interest rate volatility to interest rate l evels has been overstated in the literature. While this relationship i s important, adequately modeling volatility as a function of unexpecte d information shocks is also important. Second, we conclude that the v olatility processes in many existing theoretical models of interest ra tes are misspecified, and suggest new paths toward improving the theor y.