Review of Quantitative Finance and Accounting, 12 (1999): 351±370
# 1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
On the Nonlinear Speci®cations of Short-Term Interest
Rate Behavior: Evidence from
THOMAS C. CHIANG, Ph.D.
Marshall M. Austin Professor, Drexel University
JEANETTE JIN CHIANG, Ph.D.
Abstract. This paper presents a coherent nonlinear interest rate model that incorporates the dynamics of the
error correction speci®cation into the traditional term structure model. The joint tests based on six Euro-Currency
rates indicate that the linear speci®cation should be rejected. The estimated equation suggests that the linear
componentsÐthe change of the long-term interest rate and the error correcting term are highly signi®cant. The
nonlinear components involving the higher order of the independent variables, the cross products, the lagged error
squares, and/or the ARCH effect also present signi®cant explanatory power for predicting short-term Euro-
Currency rate changes, con®rming the non-linear speci®cations.
Key words: Euro currency, nonlinear models, error correction model, term structure of interest rates
JEL Classi®cation: E43 and F3
Recent empirical studies on interest rate time series have arrived at several important
®ndings. First, the statistical tests (Dickey-Fuller; Augmented Dickey-Fuller; and Phillips
and Perron) fail to reject unit roots in the levels of interest rates, hence there is evidence,
albeit inconclusive, that the levels of the interest rates are nonstationary (Choi and Wohar
(1991), Mougoue (1992), Chiang and Chiang (1995)). Second, cointegration tests provide
sound evidence attesting to the fact that the interest rates tend to follow a common
stochastic trend (Arshanaplli and Doukas (1994), Engsted and Tanggaard (1994)),
pointing out that short-term interest rates have a tendency to move together closely. Third,
some evidence shows that the unbiased expectation hypothesis of the term structure of
interest rates performs better in the recent data, Mishkin (1988)), indicating that the
changes in short-term interest rates can be predicted by the slope of the yield curve.
The empirical evidence gathered to date carries two important implications. First, since
the coef®cient of the long-run equilibrium equation in the term structure of interest rate
model, is close to unity, the error correction term will contain information very similar to
that offered by the slope of the yield curve. Second, the error correction model (ECM)
appears to be a more appropriate representation for describing the interest rate behavior
since it contains both the short-run dynamics and the long-run equilibrium characteristics.