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Testing for the Diffusion Matrix in a Continuous-Time Markov Process Model with Applications to the Term Structure of Interest Rates

Fuchun Li

Staff Working Papers from Bank of Canada

Abstract: The author proposes a test for the parametric specification of each component in the diffusion matrix of a d-dimensional diffusion process. Overall, d (d-1)/2 test statistics are constructed for the off-diagonal components, while d test statistics are constructed for the main diagonal components. Using theories of degenerate U-statistics, each of these test statistics is shown to follow an asymptotic standard normal distribution under null hypothesis, while diverging to infinity if the component is misspecified over a significant range. Our tests strongly reject the specification of diffusion functions in a variety of popular univariate interest rate models for daily 7-day eurodollar spot rates, and the specification of the diffusion matrix in some popular multivariate affine term-structure models for monthly U.S. Treasury yields.

Keywords: Asset Pricing; Econometric and statistical methods; Interest rates (search for similar items in EconPapers)
JEL-codes: C12 C14 E17 E43 G12 G20 (search for similar items in EconPapers)
Pages: 57 pages
Date: 2015
New Economics Papers: this item is included in nep-ecm, nep-mac and nep-ore
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