The elasticity of interest rate volatility:

This paper presents a careful reexamination of the results of Chan, Karolyi, Longstaff, and Sanders (CKLS) in Journal of Finance, 47 (1992), 1209±1227. By rede®ning the possible regime shift period in line with evidence from known policy changes and past empirical research, the present authors ®nd evidence that contradicts the major results in their paper. The widely cited conclusion of their paper is that the elasticity of interest rate volatility, the coef®cient linking interest rate volatility to interest rate levels, is 1.5. CKLS also concluded that there was no structural shift in the interest rate process after October 1979. When the structural shift period is de®ned to be temporary and coincident with the Federal Reserve Experiment of October 1979 through September 1982, it is found that there is strong evidence of a structural break. Furthermore, there is also evidence that, contrary to CKLS's claim, a moderately elastic interest rate process can capture the dependence of volatility on the level of interest rates, while highly elastic models cannot. In particular, this study ®nds support for the square-root Cox± Ingersoll±Ross process. 1