The Dynamics of Short-Term Interest Rate Volatility Reconsidered

In this paper we present and estimate a model of short-term interest rate volatility that encompasses both the level effect of Chan, Karolyi, Longstaff and Sanders (1992) and the conditional heteroskedasticity effect of the GARCH class of models. This flexible specification allows different effects to dominate as the level of the interest rate varies. We also investigate implications for the pricing of bond options. Our findings indicate that the inclusion of a volatility effect reduces the estimate of the level effect, and has option implications that differ significantly from the Chan, Karolyi, Longstaff and Sanders (1992) model.