Macroeconomic Dynamics, 1, 1997, 135-158.

Estimation of Continuous-Time

Models for Stock Returns And Interest Rates

University of North Carolina

Duke University

Efficient Method of Moments is used to estimate and test continuous-time diffusion models for stock returns and interest rates. For stock returns, a four-state, two-factor diffusion with one state observed can account for the dynamics of the daily return on the S&P Composite Index, 1927-1987. This contrasts with results indicating that discrete-time, stochastic volatility models cannot explain these dynamics. For interest rates, a trivariate Yield-Factor Model is estimated from weekly, 1962-1995, Treasury rates. The Yield-Factor Model is sharply rejected, although extensions permitting convexities in the local variance come closer to fitting the data.

Keywords: Continuous Time Models, Diffusion Models, Efficient Method of Moments, Stochastic Differential Equations, Stock Returns, Interest Rates, Yield Factor Model.