Estimating Parameters of Short-Term Real Interest Rate Models

Vadim Khramov

No 2013/212, IMF Working Papers from International Monetary Fund

Abstract: This paper sheds light on a narrow but crucial question in finance: What should be the parameters of a model of the short-term real interest rate? Although models for the nominal interest rate are well studied and estimated, dynamics of the real interest rate are rarely explored. Simple ad hoc processes for the short-term real interest rate are usually assumed as building blocks for more sophisticated models. In this paper, parameters of the real interest rate model are estimated in the broad class of single-factor interest rate diffusion processes on U.S. monthly data. It is shown that the elasticity of interest rate volatility—the relationship between the volatility of changes in the interest rate and its level—plays a crucial role in explaining real interest rate dynamics. The empirical estimates of the elasticity of the real interest rate volatility are found to be about 0.5, much lower than that of the nominal interest rate. These estimates show that the square root process, as in the Cox-Ingersoll-Ross model, provides a good characterization of the short-term real interest rate process.

Keywords: WP; real interest rate; nominal interest rate; real interest rate model; Single-factor Models; Short-term Interest Rate; inflation expectation; nominal interest rate model; data series; real interest rate process; diffusion process; Real interest rates; Interest rate modelling; Short term interest rates; Inflation; Yield curve (search for similar items in EconPapers)
Pages: 27
Date: 2013-10-17
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