Estimation and Specification Test for Diffusion Models with Stochastic Volatility

Abstract

Given the importance of continuous-time stochastic volatility models to describe the dynamics of interest rates, we propose a goodness-of-fit test for the parametric form of the drift and diffusion functions, based on a marked empirical process of the residuals. The test statistics are constructed using a continuous functional (Kolmogorov-Smirnov and Cram\'er-von Mises) over the empirical processes. In order to evaluate the proposed tests, we implement a simulation study, where a bootstrap method is considered for the calibration of the tests. As the estimation of diffusion models with stochastic volatility based on discretely sampled data has proven difficult, we address this issue by means of a Monte Carlo study for different estimation procedures. Finally, an application of the procedures to real data is provided.