The Realized Empirical Distribution Function of Stochastic Variance with Application to Goodness-of-Fit Testing

48 Pages Posted: 24 Jul 2018 Last revised: 25 Jun 2019

Date Written: April 30, 2019

Abstract

We propose a nonparametric estimator of the empirical distribution function (EDF) of the latent spot variance of the log-price of a financial asset. We show that over a fixed time span our realized EDF (or REDF)-inferred from noisy high-frequency data-is consistent as the mesh of the observation grid goes to zero. In a double-asymptotic framework, with time also increasing to infinity, the REDF converges to the cumulative distribution function of volatility, if it exists. We exploit these results to construct some new goodness-of-fit tests for stochastic volatility models. In a Monte Carlo study, the REDF is found to be accurate over the entire support of volatility. This leads to goodness-of-fit tests that are both correctly sized and relatively powerful against common alternatives. In an empirical application, we recover the REDF from stock market high-frequency data. We inspect the goodness-of-fit of several two-parameter marginal distributions that are inherent in standard stochastic volatility models. The inverse Gaussian offers the best overall description of random equity variation, but the fit is less than perfect. This suggests an extra parameter (as available in, e.g., the generalized inverse Gaussian) is required to model stochastic variance.

Keywords: empirical processes; goodness-of-fit; high-frequency data; microstructure noise; pre-averaging; realized variance; stochastic volatility

JEL Classification: C10; C50

Suggested Citation

Christensen, Kim and Thyrsgaard, Martin and Veliyev, Bezirgen, The Realized Empirical Distribution Function of Stochastic Variance with Application to Goodness-of-Fit Testing (April 30, 2019). Available at SSRN: https://ssrn.com/abstract=3206896 or http://dx.doi.org/10.2139/ssrn.3206896

Kim Christensen (Contact Author)

Aarhus University - CREATES ( email )

Department of Economics and Business Economics
Fuglesangs Allé 4
Aarhus V, 8210
Denmark

Martin Thyrsgaard

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Bezirgen Veliyev

Aarhus University ( email )

CREATES
Fuglesangs Alle 4
DK-8210 Aarhus V, 8210
Denmark

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