THE UNIVERSITY OF MELBOURNE.pdfVIP

ISSN 0819-2642 ISBN 0 7340 2601 3 THE UNIVERSITY OF MELBOURNE DEPARTMENT OF ECONOMICS RESEARCH PAPER NUMBER 945 AUGUST 2005 TESTING FOR ASYMMETRY IN INTEREST RATE VOLATILITY IN THE PRESENCE OF A NEGLECTED LEVEL EFFECT by Olan T. Henry Sandy Suardi Department of Economics The University of Melbourne Melbourne Victoria 3010 Australia. Testing for Asymmetry in Interest Rate Volatility in the Presence of a Neglected Level Effect∗ Ólan T. Henry† Department of Economics, The University of Melbourne Sandy Suardi School of Economics, The University of Queensland August 11, 2005 Abstract Empirical evidence documents a level effect in the volatility of short term rates of interest. That is, volatility is positively correlated with the level of the short term interest rate. Using Monte-Carlo simulations this paper examines the performance of the commonly used Engle-Ng (1993) tests which differentiate the effect of good and bad news on the predictability of future short rate volatility. Our results show that the tests exhibit serious size distortions and loss of power in the face of a neglected level effect. Keywords: Level Effects; Asymmetry; Engle-Ng Tests J.E.L. Reference Numbers: C12; G12; E44 ∗Discussions with Nilss Olekal