Nonparametric Density Estimation and Tests of Continuous Time Interest Rate Models.

I study the finite sample distribution of one of Ait-Sahalia's (1996c) nonparametric tests of continuous-time models of the short-term riskless rate. The test rejects true models too often because interest rate data are highly persistent but the asymptotic distribution of the test (and of the kernel density estimator on which the test is based) treats the data as if it were independently and identically distributed. To attain the accuracy of the kernel density estimator implied by its asymptotic distribution with 22 years of data generated from the Vasicek model in fact requires 2755 years of data. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.