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RFS Advance Access originally published online on December 10, 2007
Review of Financial Studies 2008 21(1):311-346; doi:10.1093/rfs/hhm072
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Right arrow E43 - Determination of Interest Rates; Term Structure of Interest Rates
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© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

Is Nonlinear Drift Implied by the Short End of the Term Structure?

Hideyuki Takamizawa
Graduate School of Humanities and Social Sciences, University of Tsukuba

Address correspondence to H. Takamizawa, Graduate School of Humanities and Social Sciences, University of Tsukuba, Tsukuba Ibaraki 305-8571, Japan; e-mail: takamiza{at}social.tsukuba.ac.jp.

JEL Classification: C51, E43, G12


  Abstract

Nonlinear drift models of the short rate are estimated using data on the short end of the term structure, where the cross-sectional relation is obtained by an analytical approximation. The findings reveal that (i) nonlinear physical drift is not implied unless it is strongly affected by cross-sectional dimensions of the data; (ii) nonlinear risk-neutral drift that allows for fast mean reversion for high rates is desirable to explain and predict observed patterns of yield spreads; and (iii) for higher frequency data from which transitory shocks are removed, (ii) still remains valid although the nonlinearity is somewhat reduced.

I would like to thank Yacine Aït-Sahalia (the editor) and an anonymous referee for comments and suggestions, which greatly improved the paper. I am also grateful to Alfredo Ferreira for helpful discussion. All errors are my own.


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