A comparison of international short-term rates under no arbitrage condition

The short-term interest rate is an important economic variable and its time series properties have been the subject of numerous empirical studies. This paper provides empirical evidence on the behavior of short-term rates in seven industrialized countries and the Euro zone under the no-arbitrage condition. Under such conditions the expected change in the short-term rate is related to the current slope of the term structure of interest rates. Previous estimates of the short-term rate process fail to account for this relationship, which imposes certain restrictions on the drift of the short-term rate. We show that when such restrictions are taken into account, the estimate of the short-term rate volatility is affected. Also, the no-arbitrage restriction allows us to estimate the market price of interest risk. We use the GMM approach to estimate the model for US, UK, Canada, Japan, Australia, Denmark, Sweden and the Euro zone. Our estimates show that no single model can explain the short-term process for all of these countries. Also, our results show that the market price of interest rate risk is highly non-linear but generally increasing in the level of the short-term rate.