Finance

Chan, Karolyi, Longstaff, and Sanders [1992] find no evidence that the October 1979 change in Federal Reserve operating policy resulted in a once-and-for-all deterministic break in the behavior of short term riskless interest rates. In contrast, we provide evidence of such a regime shift even after allowing the volatility of interest rate changes to depend on the level of interest rates. However, rather than modeling this regime-shift as a permanent event with no further shifts possible, it is more realistic to model the change in regimes itself as a random variable. Accordingly, we put forward a stochastic volatility interest rate model which generalizes previous specifications of interest rate dynamics and allowed testing for stochastic regime shifts. This Markov regime shifting model provides a more accurate description of the behavior of U.S. short term riskless interest rates. We also consider a specification that allows interest rate volatility to follow a diffusion proves and we provide a statistically efficient integration-based filtering procedure to estimate its parameters. Five U.S. short term riskless interest rate data, we cannot statistically distinguish between these alternative models. In either case, once the stochastic nature of interest rate volatility is taken in account, we find little or no evidence of a deterministic structural break in corresponding stochastic volatility interest rate dynamics around October 1979.