Reducible Diffusions with Time-Varying Transformations with Application to Short-Term Interest Rates

Ruijun Bu, Jie Cheng and Kaddour Hadri

No 14-01, Economics Working Papers from Queen's Management School, Queen's University Belfast

Abstract: Reducible diffusions (RDs) are nonlinear transformations of analytically solvable Basic Diffusions (BDs). Therefore, they are constructed to be analytically tractable and flexible diffusion processes. Existing literature on RDs has mostly focused on time-homogeneous transformations, which to a significant extent fail to explore the full potential of RDs from both theoretical and practical point of views. In this paper, we propose flexible and economically justifiable time-variations to the transformations of RDs. Concentrating on the Constant Elasticity Variance (CEV) RDs, we consider nonlinear dynamics for our time-varying transformations with both deterministic and stochastic designs. Such time-variations can greatly enhance the flexibility of RDs while maintain sufficient tractability of the resulting models. Our approach also enjoys the benefits of classical inferential techniques as much as the advocated time-varying nonlinear dynamics. Our application to UK and US short-term interest rates suggests that from an empirical point of view time-varying transformations are highly relevant and statistically significant.

Keywords: Stochastic Differential Equation; Reducible Diffusion; Constant Elasticity Variance; Time-Varying Transformation; Maximum Likelihood Estimation; Short-Term Interest Rate (search for similar items in EconPapers)
JEL-codes: C13 C32 G12 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2014
New Economics Papers: this item is included in nep-ecm
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Journal Article: Reducible diffusions with time-varying transformations with application to short-term interest rates (2016)
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