Working Paper No. 16
By Bahram Pesaran and Gary Robinson
We present a statistical analysis of sterling libor interest rates in two monetary regimes: free-floating of sterling, prior to ERM entry, and the recent ERM regime. Our findings indicate that short-term interest rates follow a random walk with time-varying volatility, and increments drawn from a kurtotic distribution. Moreover, we find that the process followed by the short rate is sensitive to the regime: interest rate changes observed in the floating-rate regime are drawn from a distribution with much fatter tails (the Cauchy distribution) than for the ERM regime (t-distribution). This characterisation of the process followed by the short interest rate is inconsistent with existing pricing models for interest-rate-derivative securities, which assume either that short rates follow simple Geometric Brownian Motion, or that they are mean-reverting.