Modeling interest rate volatility: an extended EGARCH approach

Purpose – This paper aims to propose a general, yet simple model to estimate interest rate volatility. Design/methodology/approach – The methodology is based on an extended Exponential Generalized ARCH (EGARCH) model that incorporates both interest rate levels as well as past information shocks in the volatility function. More importantly, the model is log‐linear thus eliminating collinearity problems and it can be easily estimated using standard maximum likelihood techniques. Findings – The empirical evidence suggests that the elasticity of volatility to the level of interest rates, although statistically significant, is not as high numerically as previously thought. In fact innovations in the interest rate process are more significant than the level of interest rates. The most important feature of interest rates, however, is the high volatility persistence. Research limitations/implications – A limitation of the model is that it does not allow for structural shifts in its current form. Extending the model to accommodate possible shifts would probably improve the performance as well the forecasting accuracy. Practical implications – The findings in this paper have important implications for the accurate pricing of fixed income derivative securities as well as the efficient risk management of fixed income portfolios. Originality/value – The paper provides a convenient and unifying methodological framework for assessing the importance and forecasting ability of the various volatility components.