On the Correlation Structure of Microstructure Noise: A Financial Economic Approach
AbstractWe introduce the financial economics of market microstructure into the financial econometrics of asset return volatility estimation. In particular, we use market microstructure theory to derive the cross-correlation function between latent returns and market microstructure noise, which feature prominently in the recent volatility literature. The cross-correlation at zero displacement is typically negative, and cross- correlations at nonzero displacements are positive and decay geometrically. If market makers are sufficiently risk averse, however, the cross-correlation pattern is inverted. We derive model-based volatility estimators, which we apply to stock and oil prices. Our results are useful for assessing the validity of the frequently-assumed independence of latent price and microstructure noise, for explaining observed cross-correlation patterns, for predicting as-yet undiscovered patterns, and for microstructure-based volatil- ity estimation.
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Bibliographic InfoPaper provided by Boston College Department of Economics in its series Boston College Working Papers in Economics with number 693.
Date of creation: 09 Oct 2008
Date of revision: 24 Apr 2012
Note: previously circulated as "On the Correlation Structure of Microstructure Noise in Theory and Practice"
Contact details of provider:
Postal: Boston College, 140 Commonwealth Avenue, Chestnut Hill MA 02467 USA
Web page: http://fmwww.bc.edu/EC/
More information through EDIRC
Realized volatility; Market microstructure theory; High-frequency data; Financial econometrics;
Other versions of this item:
- Francis X. Diebold & Georg Strasser, 2010. "On the Correlation Structure of Microstructure Noise: A Financial Economic Approach," NBER Working Papers 16469, National Bureau of Economic Research, Inc.
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
- G20 - Financial Economics - - Financial Institutions and Services - - - General
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
- C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-11-18 (All new papers)
- NEP-ECM-2008-11-18 (Econometrics)
- NEP-ETS-2008-11-18 (Econometric Time Series)
- NEP-MST-2008-11-18 (Market Microstructure)
- NEP-UPT-2008-11-18 (Utility Models & Prospect Theory)
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