Data-driven smooth tests for the martingale difference hypothesis

A general method for testing the martingale difference hypothesis is proposed. The new tests are data-driven smooth tests based on the principal components of certain marked empirical processes that are asymptotically distribution-free, with critical values that are already tabulated. The smooth tests are shown to be optimal in a semiparametric sense discussed in the paper, and they are robust to conditional heteroscedasticity of unknown form. A simulation study shows that the data-driven smooth tests perform very well for a wide range of realistic alternatives and have more power than omnibus and other competing tests. Finally, an application to the S&P 500 stock index and some of its components highlights the merits of our approach. The paper also contains a new weak convergence theorem that is of independent interest.

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