Modeling Short-Term Interest Rate Volatility

Abstract

This article investigates the impact of information shocks and interest rate levels on the volatility of six national short-term interest rates. Short-term rates are assumed to follow a single-factor diffusion process that tests several popular models that have been used in literature. The elasticity of variance with respect to the level of interest rates is not as important as reported by some researchers. In fact, models using only information shocks perform better than models using only levels. In all cases, however, the best volatility specification requires the use of both information shocks and interest rate levels. Mean reversion does not appear to be an important feature of short-term interest rates.