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A Damped Diffusion Framework for Financial Modeling and Closed-form Maximum Likelihood Estimation

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Author Info
Li, Minqiang

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Abstract

Asset price bubbles can arise unintentionally when one uses continuous-time diffusion processes to model financial quantities. We propose a flexible damped diffusion framework that is able to break many types of bubbles and preserve the martingale pricing approach. Damping can be done on either the diffusion or drift function. Oftentimes, certain solutions to the valuation PDE can be ruled out by requiring the solution to be a limit of martingale prices for damped diffusion models. Monte Carlo study shows that with finite time-series length, maximum likelihood estimation often fails to detect the damped diffusion function while fabricates nonlinear drift function.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 11185.

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Date of creation: 30 Jul 2008
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Handle: RePEc:pra:mprapa:11185

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Related research
Keywords: Damped diffusion; asset price bubbles; martingale pricing; maximum likelihood estimation;

Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
C60 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - General

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