A three-factor model with a market sensitivity parameter to estimate the dynamics of the short rate: An application for the Mexican government funding rate

Abstract

In this study we develop a three-factor model of the term structure of interest rates that includes a market sensitivity parameter. In the model the future short-rate depends on the current short-rate, the short-term mean of the short rate and the current volatility of the short-rate. The parameter measures the impact of the volatility on the short rate. The model is used to estimate the dynamics of the Mexican short rate. The methodology to estimate the term structure uses three-stage least squares (3SLS) and full-information maximum likelihood (FIML) estimations and Monte Carlo simulations. The results suggest that the model fits better than the CIR one to describe and predict the Mexican government funding rate.term structure; short rate; market sensitivity; government funding rate; Mexico