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RFS Advance Access originally published online on March 26, 2004
Review of Financial Studies 2005 18(1):37-84; doi:10.1093/rfs/hhh006
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The Review of Financial Studies Vol. 18, No. 1 © 2005 The Society for Financial Studies; all rights reserved.

Nonparametric Specification Testing for Continuous-Time Models with Applications to Term Structure of Interest Rates

Yongmiao Hong
Cornell University and Tsinghua University

Haitao Li
Cornell University

Address correspondence to: Yongmiao Hong, Department of Economics and Department of Statistical Science, Cornell University, 424 Uris Hall, Ithaca, NY 14850, or e-mail: yh20{at}cornell.edu

We develop a nonparametric specification test for continuous-time models using the transition density. Using a data transform and correcting for the boundary bias of kernel estimators, our test is robust to serial dependence in data and provides excellent finite sample performance. Besides univariate diffusion models, our test is applicable to a wide variety of continuous-time and discrete-time dynamic models, including time-inhomogeneous diffusion, GARCH, stochastic volatility, regime-switching, jump-diffusion, and multivariate diffusion models. A class of separate inference procedures is also proposed to help gauge possible sources of model misspecification. We strongly reject a variety of univariate diffusion models for daily Eurodollar spot rates and some popular multivariate affine term structure models for monthly U.S. Treasury yields.


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