Reducible diffusions with time-varying transformations with application to short-term interest rates

Bu, Ruijun ORCID: 0000-0002-3947-3038, Cheng, Jie and Hadri, Kaddour (2016) Reducible diffusions with time-varying transformations with application to short-term interest rates. ECONOMIC MODELLING, 52. pp. 266-277.

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Abstract

Reducible diffusions (RDs) are nonlinear transformations of analytically solvable Basic Diffusions (BDs). Hence, by construction RDs are analytically tractable and flexible diffusion processes. Existing literature on RDs has mostly focused on time-homogeneous transformations, which to a significant extent fail to explore the full potential of RDs from both theoretical and practical points of view. In this paper, we propose flexible and economically justifiable time variations to the transformations of RDs. Concentrating on the Constant Elasticity Variance (CEV) RDs, we consider nonlinear dynamics for our time-varying transformations with both deterministic and stochastic designs. Such time variations can greatly enhance the flexibility of RDs while maintaining sufficient tractability of the resulting models. In the meantime, our modeling approach enjoys the benefits of classical inferential techniques such as the Maximum Likelihood (ML). Our application to the UK and the US short-term interest rates suggests that from an empirical point of view time-varying transformations are highly relevant and statistically significant. We expect that the proposed models can describe more truthfully the dynamic time-varying behavior of economic and financial variables and potentially improve out-of-sample forecasts significantly.

Item Type:	Article
Uncontrolled Keywords:	Stochastic differential equation, Reducible diffusion, Constant elasticity variance, Time-varying transformation, Maximum likelihood estimation, Short-term interest rate
Subjects:	?? HA ?? ?? HG ?? ?? QA ??
Depositing User:	Symplectic Admin
Date Deposited:	03 Feb 2016 09:10
Last Modified:	16 Dec 2022 16:45
DOI:	10.1016/j.econmod.2014.10.039
Related URLs:	Author Publisher
URI:	https://livrepository.liverpool.ac.uk/id/eprint/2049789