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Modeling the Epps effect of cross correlations in asset prices

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  • Bence Toth
  • Balint Toth
  • Janos Kertesz

Abstract

We review the decomposition method of stock return cross-correlations, presented previously for studying the dependence of the correlation coefficient on the resolution of data (Epps effect). Through a toy model of random walk/Brownian motion and memoryless renewal process (i.e. Poisson point process) of observation times we show that in case of analytical treatability, by decomposing the correlations we get the exact result for the frequency dependence. We also demonstrate that our approach produces reasonable fitting of the dependence of correlations on the data resolution in case of empirical data. Our results indicate that the Epps phenomenon is a product of the finite time decay of lagged correlations of high resolution data, which does not scale with activity. The characteristic time is due to a human time scale, the time needed to react to news.

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  • Bence Toth & Balint Toth & Janos Kertesz, 2007. "Modeling the Epps effect of cross correlations in asset prices," Papers 0704.3798, arXiv.org.
    • Handle: RePEc:arx:papers:0704.3798
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    File URL: http://arxiv.org/pdf/0704.3798
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    Cited by:

    1. Iacopo Mastromatteo & Matteo Marsili & Patrick Zoi, 2010. "Financial correlations at ultra-high frequency: theoretical models and empirical estimation," Papers 1011.1011, arXiv.org, revised Feb 2011.

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