A General Approach to Testing Volatility Models in Time Series

Volatility models have been playing important roles in economics and finance. Using a generalized spectral second order derivative approach, we propose a new class of generally applicable omnibus tests for the adequacy of linear and nonlinear volatility models. Our tests have a convenient asymptotic null N(0,1) distribution, and can detect a wide range of misspecifications for volatility dynamics, including both neglected linear and nonlinear volatility dynamics. Distinct from the existing diagnostic tests for volatility models, our tests are robust to time-varying higher order moments of unknown form (e.g., time-varying skewness and kurtosis). They check a large number of lags and are therefore expected to be powerful against neglected volatility dynamics that occurs at higher order lags or display long memory properties. Despite using a large number of lags, our tests do not suffer much from the loss of a large number of degrees of freedom, because our approach naturally discounts higher order lags, which is consistent with the stylized fact that economic or financial markets are affected more by the recent past events than by the remote past events. No specific estimation method is required, and parameter estimation uncertainty has no impact on the convenient limit N(0,1) distribution of the test statistics. Moreover, there is no need to formulate an alternative volatility model, and only estimated standardized residuals are needed to implement our tests. We do not have to calculate tedious and model-specific score functions or derivatives of volatility models with respect to estimated parameters, which are required in some existing popular diagnostic tests for volatility models. We examine the finite sample performance of the proposed tests. It is documented that the new tests are rather powerful in detecting neglected nonlinear volatility dynamics which the existing tests can easily miss. They are useful diagnostic tools for practitioners when modelling volatility dynamics.