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101
Testing ContinuousTime Models of the Spot Interest Rate
 Review of Financial Studies
, 1996
"... Different continuoustime models for interest rates coexist in the literature. We test parametric models by comparing their implied parametric density to the same density estimated nonparametrically. We do not replace the continuoustime model by discrete approximations, even though the data are rec ..."
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Cited by 194 (7 self)
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Different continuoustime models for interest rates coexist in the literature. We test parametric models by comparing their implied parametric density to the same density estimated nonparametrically. We do not replace the continuoustime model by discrete approximations, even though the data are recorded at discrete intervals. The principal source of rejection of existing models is the strong nonlinearity of the drift. Around its mean, where the drift is essentially zero, the spot rate behaves like a random walk. The drift then meanreverts strongly when far away from the mean. The volatility is higher when away from the mean. The continuoustime financial theory has developed extensive tools to price derivative securities when the underlying traded asset(s) or nontraded factor(s) follow stochastic differential equations [see Merton (1990) for examples]. However, as a practical matter, how to specify an appropriate stochastic differential equation is for the most part an unanswered question. For example, many different continuoustime The comments and suggestions of Kerry Back (the editor) and an anonymous referee were very helpful. I am also grateful to George Constantinides,
An empirical investigation of continuoustime equity return models
 Journal of Finance
, 2002
"... This paper extends the class of stochastic volatility diffusions for asset returns to encompass Poisson jumps of timevarying intensity. We find that any reasonably descriptive continuoustime model for equityindex returns must allow for discrete jumps as well as stochastic volatility with a pronou ..."
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Cited by 134 (10 self)
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This paper extends the class of stochastic volatility diffusions for asset returns to encompass Poisson jumps of timevarying intensity. We find that any reasonably descriptive continuoustime model for equityindex returns must allow for discrete jumps as well as stochastic volatility with a pronounced negative relationship between return and volatility innovations. We also find that the dominant empirical characteristics of the return process appear to be priced by the option market. Our analysis indicates a general correspondence between the evidence extracted from daily equityindex returns and the stylized features of the corresponding options market prices. MUCH ASSET AND DERIVATIVE PRICING THEORY is based on diffusion models for primary securities. However, prescriptions for practical applications derived from these models typically produce disappointing results. A possible explanation could be that analytic formulas for pricing and hedging are available for only a limited set of continuoustime representations for asset returns
A Nonparametric Model of Term Structure Dynamics and the Market Price of Interest Rate Risk
, 1997
"... This article presents a technique for nonparametrically estimating continuoustime di#usion processes which are observed at discrete intervals. We illustrate the methodology by using daily three and six month Treasury Bill data, from January 1965 to July 1995, to estimate the drift and di#usion of t ..."
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Cited by 126 (5 self)
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This article presents a technique for nonparametrically estimating continuoustime di#usion processes which are observed at discrete intervals. We illustrate the methodology by using daily three and six month Treasury Bill data, from January 1965 to July 1995, to estimate the drift and di#usion of the short rate, and the market price of interest rate risk. While the estimated di#usion is similar to that estimated by Chan, Karolyi, Longsta# and Sanders (1992), there is evidence of substantial nonlinearity in the drift. This is close to zero for low and medium interest rates, but mean reversion increases sharply at higher interest rates.
Do stock prices and volatility jump? Reconciling evidence from spot and option prices
, 2001
"... This paper studies the empirical performance of jumpdiffusion models that allow for stochastic volatility and correlated jumps affecting both prices and volatility. The results show that the models in question provide reasonable fit to both option prices and returns data in the insample estimation ..."
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Cited by 97 (2 self)
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This paper studies the empirical performance of jumpdiffusion models that allow for stochastic volatility and correlated jumps affecting both prices and volatility. The results show that the models in question provide reasonable fit to both option prices and returns data in the insample estimation period. This contrasts previous findings where stochastic volatility paths are found to be too smooth relative to the option implied dynamics. While the models perform well during the high volatility estimation period, they tend to overprice long dated contracts outofsample. This evidence points towards a too simplistic specification of the mean dynamics of volatility.
MCMC Analysis of Diffusion Models with Application to Finance
 Journal of Business and Economic Statistics
, 1998
"... This paper proposes a new method for estimation of parameters in diffusion processes from ..."
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Cited by 88 (3 self)
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This paper proposes a new method for estimation of parameters in diffusion processes from
Numerical Techniques for Maximum Likelihood Estimation of ContinuousTime Diffusion Processes
 JOURNAL OF BUSINESS AND ECONOMIC STATISTICS
, 2001
"... Stochastic differential equations often provide a convenient way to describe the dynamics of economic and financial data, and a great deal of effort has been expended searching for efficient ways to estimate models based on them. Maximum likelihood is typically the estimator of choice; however, sinc ..."
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Cited by 87 (0 self)
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Stochastic differential equations often provide a convenient way to describe the dynamics of economic and financial data, and a great deal of effort has been expended searching for efficient ways to estimate models based on them. Maximum likelihood is typically the estimator of choice; however, since the transition density is generally unknown, one is forced to approximate it. The simulationbased approach suggested by Pedersen (1995) has great theoretical appeal, but previously available implementations have been computationally costly. We examine a variety of numerical techniques designed to improve the performance of this approach. Synthetic data generated by a CIR model with parameters calibrated to match monthly observations of the U.S. shortterm interest rate are used as a test case. Since the likelihood function of this process is known, the quality of the approximations can be easily evaluated. On data sets with 1000 observations, we are able to approximate the maximum likelihood estimator with negligible error in well under one minute. This represents something on the order of a 10,000fold reduction in computational effort as compared to implementations without these enhancements. With other parameter settings designed to stress the methodology, performance remains strong. These ideas are easily generalized to multivariate settings and (with some additional work) to latent variable models. To illustrate, we estimate a simple stochastic volatility model of the U.S. shortterm interest rate.
How often to sample a continuoustime process in the presence of market microstructure noise
 Review of Financial Studies
, 2005
"... In theory, the sum of squares of log returns sampled at high frequency estimates their variance. When market microstructure noise is present but unaccounted for, however, we show that the optimal sampling frequency is finite and derives its closedform expression. But even with optimal sampling, usi ..."
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Cited by 86 (13 self)
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In theory, the sum of squares of log returns sampled at high frequency estimates their variance. When market microstructure noise is present but unaccounted for, however, we show that the optimal sampling frequency is finite and derives its closedform expression. But even with optimal sampling, using say 5min returns when transactions are recorded every second, a vast amount of data is discarded, in contradiction to basic statistical principles. We demonstrate that modeling the noise and using all the data is a better solution, even if one misspecifies the noise distribution. So the answer is: sample as often as possible. Over the past few years, price data sampled at very high frequency have become increasingly available in the form of the Olsen dataset of currency exchange rates or the TAQ database of NYSE stocks. If such data were not affected by market microstructure noise, the realized volatility of the process (i.e., the average sum of squares of logreturns sampled at high frequency) would estimate the returns ’ variance, as is well known. In fact, sampling as often as possible would theoretically produce in the limit a perfect estimate of that variance. We start by asking whether it remains optimal to sample the price process at very high frequency in the presence of market microstructure noise, consistently with the basic statistical principle that, ceteris paribus, more data are preferred to less. We first show that, if noise is present but unaccounted for, then the optimal sampling frequency is finite, and we We are grateful for comments and suggestions from the editor, Maureen O’Hara, and two anonymous
Reprojecting Partially Observed Systems with Application to Interest Rate Diffusions from January 5, 1992, to March 31, 1995
, 1996
"... We introduce reprojection as a general purpose technique for characterizing the observable dynamics of a partially observed nonlinear system. System parameters are estimated by method of moments wherein moments implied by the system are matched to moments implied by the transition density for observ ..."
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Cited by 81 (13 self)
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We introduce reprojection as a general purpose technique for characterizing the observable dynamics of a partially observed nonlinear system. System parameters are estimated by method of moments wherein moments implied by the system are matched to moments implied by the transition density for observables that is determined by projecting the data onto its Hermite representation. Reprojection imposes the constraints implied by the system on the transition density and is accomplished by projecting a long simulation of the estimated system onto the Hermite representation. We utilize the technique to assess the dynamics of several diffusion models for the shortterm interest rate that have been proposed and compare them to a new model that has feedback from the interest rate into both the drift and diffusion coefficients of a volatility equation. This effort entails the development of new graphical diagnostics.
A Study towards a Unified Approach to the Joint Estimation of Objective and Risk Neutral Measures for the Purpose of Options Valuation
, 1999
"... The purpose of this paper is to bridge two strands of the literature, one pertaining to the objectiveorphysical measure used to model the underlying asset and the other pertaining to the riskneutral measure used to price derivatives. We propose a generic procedure using simultaneously the fundame ..."
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Cited by 74 (4 self)
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The purpose of this paper is to bridge two strands of the literature, one pertaining to the objectiveorphysical measure used to model the underlying asset and the other pertaining to the riskneutral measure used to price derivatives. We propose a generic procedure using simultaneously the fundamental price S t and a set of option contracts ### I it # i=1;m # where m # 1 and # I it is the BlackScholes implied volatility.We use Heston's #1993# model as an example and appraise univariate and multivariate estimation of the model in terms of pricing and hedging performance. Our results, based on the S&P 500 index contract, show that the univariate approach only involving options by and large dominates. Abyproduct of this #nding is that we uncover a remarkably simple volatility extraction #lter based on a polynomial lag structure of implied volatilities. The bivariate approachinvolving both the fundamental and an option appears useful when the information from the cash market ...