Option-based tests of interest rate diffusion functions

Abstract

The consistent finding in papers that estimate the interest rate diffusion function is that interest rate volatility is an increasing function of the spot rate. This paper introduces and implements regression tests of monotonic diffusion functions using an implied volatility proxy for objective volatility. Using the case of three-month LIBOR rates, this paper documents that the relationship between interest rate levels and interest rate volatility is insignificant over the period 1985 through 1998. While rate volatility is clearly stochastic, it is not characterized by an increasing function (either linear or nonlinear) of rates.