SEM217: Alex Papanicolaou: Testing Local Volatility in Short Rate Models

Tuesday, August 30th @ 11:00-12:30 PM (639 Evans Hall)

Testing Local Volatility in Short Rate Models

Alex Papanicolaou, UC Berkeley

The first CRMR Risk Seminar of Fall 2016 features work by CDAR Postdoc Alex Papanicolaou. Abstract: We provide a simple and easy to use goodness-of-fit test for the misspecification of the volatility function in diffusion models. The test uses power variations constructed as functionals of discretely observed diffusion processes. We introduce an orthogonality condition which stabilizes the limit law in the presence of parameter estimation and avoids the necessity for a bootstrap procedure that reduces performance and leads to complications associated with the structure of the diffusion process. The test has good finite sample performance as we demonstrate in numerical simulations.