Asymptotically distribution-free tests for the volatility function of a diffusion

Qiang Chen, Xu Zheng and Zhiyuan Pan

Journal of Econometrics, 2015, vol. 184, issue 1, 124-144

Abstract: This paper develops two tests for parametric volatility function of a diffusion model based on Khmaladze (1981)’s martingale transformation. The tests impose no restrictions on the functional form of the drift function and are shown to be asymptotically distribution-free. The tests are consistent against a large class of fixed alternatives and have nontrivial power against a class of root-n local alternatives. The paper also extends the tests of volatility to testing for joint specifications of drift and volatility. Monte Carlo simulations show that the tests perform well in finite samples. The proposed tests are then applied to testing models of short-term interest, using data of Treasury bill rate and Eurodollar deposit rate. The empirical results show that the commonly used CKLS volatility function of Chan et al. (1992) fits volatility function poorly and none of the parametric interest rate models considered in the paper fit data well.

Keywords: Distribution-free tests; Volatility function; Diffusion model; Martingale transformation; Monte Carlo simulations; Interest rate volatility (search for similar items in EconPapers)
JEL-codes: C14 G21 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:econom:v:184:y:2015:i:1:p:124-144

DOI: 10.1016/j.jeconom.2014.06.020

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