The Elasticity of Interest Rate Volatility: Chan, Karolyi, Longstaff, and Sanders Revisited

Robert R. Bliss and David C. Smith
Federal Reserve Bank of Atlanta
Working Paper 97-13a
March 1998

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Abstract: This paper presents a careful reexamination of Chan, Karolyi, Longstaff, and Sanders (CKLS 1992). By redefining the possible regime shift period in line with evidence from known policy changes and past empirical research, we find evidence that contradicts the major results in their paper. The widely cited conclusion of their paper is that the elasticity of interest rate volatility is 1.5. CKLS also concluded that there was no structural shift in the interest rate process after October 1979. When the structural shift period is defined to be temporary and coincident with the Federal Reserve Experiment of October 1979 through September 1982, we find that there is strong evidence of a structural break. Furthermore, we find evidence that, contrary to CKLS's claim, a moderately elastic interest rate process can capture the dependence of volatility on the level of interest rates, while highly elastic models cannot. In particular, this study finds support for the square-root CIR process. These results are robust to changes in the short-rate data used and the treatment of outliers.

JEL classification: E40, C52

Key words: interest rate processes, model comparison, regime shifts, interest rate volatility

Formerly titled "The Stability of Interest Rate Processes." The authors acknowledge the helpful comments and suggestions of Magnus Dahlquist, John Robertson, Ehud Ronn, Tao Zha, and seminar participants at Indiana University, the University of Georgia, the Federal Reserve Bank of Atlanta, and the Norwegian School of Management. A previous version of this paper was presented at the 1997 Econometric Society North American Summer Meeting in Pasadena and the 1997 Financial Management Association Annual Meeting in Honolulu. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Robert R. Bliss, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia 30303-2713, 404/498-8757, 404/498-8810 (fax), rbliss@gsbalum.; or David C. Smith, Norwegian School of Management, Elias Smiths vei 15, PO Box 580, 1301 Sandvika, Norway, 47-67-57-05-00, 47-67-57-05-75 (fax),