Publication Type

Journal Article

Version

publishedVersion

Publication Date

6-2011

Abstract

I develop an omnibus specification test for diffusion models based on the infinitesimal operator. The infinitesimal operator based identification of the diffusion process is equivalent to a “martingale hypothesis” for the processes obtained by a transformation of the original diffusion model. My test procedure is then constructed by checking the “martingale hypothesis” via a multivariate generalized spectral derivative based approach that delivers a  asymptotical null distribution for the test statistic. The infinitesimal operator of the diffusion process is a closed-form function of drift and diffusion terms. Consequently, my test procedure covers both univariate and multivariate diffusion models in a unified framework and is particularly convenient for the multivariate case. Moreover, different transformed martingale processes contain separate information about the drift and diffusion specifications. This motivates me to propose a separate inferential test procedure to explore the sources of rejection when a parametric form is rejected. Simulation studies show that the proposed tests have reasonable size and excellent power performance. An empirical application of my test procedure using Eurodollar interest rates finds that most popular short-rate models are rejected and the drift misspecification plays an important role in such rejections.

Keywords

diffusion, infinitesimal operator, Markov, martingale problem, semi-group

Discipline

Finance | Finance and Financial Management

Research Areas

Finance

Areas of Excellence

Growth in Asia

Publication

Journal of Econometrics

Volume

162

Issue

2

First Page

189

Last Page

212

ISSN

0304-4076

Identifier

10.1016/j.jeconom.2010.12.005

Publisher

Elsevier

External URL

https://api.elsevier.com/content/abstract/scopus_id/79955063273

Additional URL

https://doi.org/10.1016/j.jeconom.2010.12.005

Download

Share

COinS