Specification Analysis of Continuous Time Models in Finance

Duke Economics Working Paper #95-49

31 Pages Posted: 18 Nov 1997

See all articles by A. Ronald Gallant

A. Ronald Gallant

Duke University - Fuqua School of Business, Economics Group; New York University - Department of Economics

George Tauchen

Duke University - Economics Group

Date Written: October 1995

Abstract

The paper describes the use of the Gallant-Tauchen efficient method of moments (EMM) technique for diagnostic checking of stochastic differential equations (SDEs) estimated from financial market data. The EMM technique is a simulation-based method that uses the score function of an auxiliary model as the criterion to define a generalized method of moments (GMM) objective function. The technique can handle multivariate SDEs where the state vector is not completely observed. The optimized GMM objective function is distributed as chi-square and may be used to test model adequacy. Elements of the score function correspond to specific parameters and large values reflect features of data that a rejected SDE specification does not describe well. The diagnostics are illustrated by estimating a three-factor model to weekly, 1962-1995, term structure data comprised of short (3 month), medium (12 month), and long (10 year) Treasury rates. The Yield-Factor Model is sharply rejected, although an extension that permits the local variance function to be a convex function of the interest rates comes much closer to describing the data.

JEL Classification: G13

Suggested Citation

Gallant, A. Ronald and Tauchen, George E., Specification Analysis of Continuous Time Models in Finance (October 1995). Duke Economics Working Paper #95-49. Available at SSRN: https://ssrn.com/abstract=40840 or http://dx.doi.org/10.2139/ssrn.40840

A. Ronald Gallant (Contact Author)

Duke University - Fuqua School of Business, Economics Group ( email )

Box 90097
Durham, NC 27708-0097
United States

New York University - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States

George E. Tauchen

Duke University - Economics Group ( email )

Box 90097
221 Social Sciences
Durham, NC 27708-0097
United States
919-660-1812 (Phone)
919-684-8974 (Fax)

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