A Damped Diffusion Framework for Financial Modeling and Closed-form Maximum Likelihood Estimation

Minqiang Li

MPRA Paper from University Library of Munich, Germany

Abstract: Asset price bubbles can arise unintentionally when one uses continuous-time diffusion processes to model financial quantities. We propose a flexible damped diffusion framework that is able to break many types of bubbles and preserve the martingale pricing approach. Damping can be done on either the diffusion or drift function. Oftentimes, certain solutions to the valuation PDE can be ruled out by requiring the solution to be a limit of martingale prices for damped diffusion models. Monte Carlo study shows that with finite time-series length, maximum likelihood estimation often fails to detect the damped diffusion function while fabricates nonlinear drift function.

Keywords: Damped diffusion; asset price bubbles; martingale pricing; maximum likelihood estimation (search for similar items in EconPapers)
JEL-codes: C60 G12 G13 (search for similar items in EconPapers)
Date: 2008-07-30
New Economics Papers: this item is included in nep-ecm and nep-ore
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Related works:
Journal Article: A damped diffusion framework for financial modeling and closed-form maximum likelihood estimation (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:11185

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