Stability of Transition Densities

Abstract

Application of continuous-time models for changes in the short-term interest rate amounts to specifying a corresponding transition density for interest rates. The author empirically evaluates the time series of transition densities obtained from popular interest rate models when implied parameter estimates from the options markets are used. The integrated absolute difference between transition densities obtained in successive periods provides a convenient method to evaluate out-of-sample performance of a model. The procedure is used to evaluate four competing modes with the data from the Eurodollar futures and options market for the period 1985–1999.