A Simple Measure for Examining the Proxy Problem of the Short-Rate

Abstract

Using finite maturity yields as proxies for the short-rate may cause estimation biases and pricing errors of interest-rate sensitive securities, which is so-called the proxy problem. We propose a simple measure for examining how severe it is by utilizing an approximate model of the term structure having the similar functional form to affine models. Also, we propose a proxy-free estimation approach by utilizing model-inversion, which provides a useful benchmark based on which we can determine a better proxy.