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RFS Advance Access published online on March 26, 2004
Review of Financial Studies, doi:10.1093/rfs/hhh006
Review of Financial Studies © The Society for Financial Studies 2004; all rights reserved
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The Review of Financial Studies © The Society for Financial Studies 2004; all rights reserved.

Original Articles

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

Yongmiao Hong 1* and Haitao Li 2
1 Department of Economics and Department of Statistical Science, Cornell University, Ithaca, New York 14853; Department of Economics, Tsinghua University, Beijing 100084, China
2 Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853

* To whom correspondence should be addressed. E-mail: yh20{at}cornell.edu.


  Abstract

We develop a nonparametric specification test for continuous-time models using the transition density. Using a data transform and correcting for 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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