SHORT-TERM INTEREST-RATES AS SUBORDINATED DIFFUSIONS

In this article we characterize and estimate the process for short-ter m interest rates using federal funds interest rate data. We presume th at we are observing a discrete-time sample of a stationary scalar diff usion. We concentrate on a class of models in which the local volatili ty elasticity is constant and the drift has a flexible specification. To accommodate missing observations and to break the link, between ''e conomic time'' and calendar time, we model the sampling scheme as an i ncreasing process that is not directly observed We propose and impleme nt two new methods for estimation. We find evidence for a volatility e lasticity between one and one-half and two. When interest rates are hi gh, local mean reversion is small and the mechanism for inducing stati onarity is the increased volatility of the diffusion process.