13.15.1.1 Traditional Academic Approach

This approach follows theory precisely to estimate the Stochastic Process for the short term risk-less rate of interest, in this case, the one-month Canadian government bill yield. This approach is generally not satisfactory in any market and was found to be unsatisfactory with Canadian data as well.

For an example of a well-done analysis of the parameters of several theoretical models, see Chan, Karolyi, Longstaff, and Sanders [4]. The study, while well done, suffers from the typical outcome of such studies: in no case does the assumed Stochastic Process explain more than three percent of the variation in the short term rate of interest. We find the same problem when running the regression on 2,320 days of data using the one-month Canadian bill rate as the short rate proxy. It is concluded that this approach is not useful in the Canadian market because of the lack of correlation between the level of interest rates and change in the level of the short rate.