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On the correlation structure of microstructure noise in theory and practice

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  • Diebold, Francis X.
  • Strasser, Georg H.

Abstract

We argue for incorporating 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. 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 making informed conjectures as to improved volatility estimation methods. --

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Bibliographic Info

Paper provided by Center for Financial Studies (CFS) in its series CFS Working Paper Series with number 2008/32.

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Date of creation: 2008
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Handle: RePEc:zbw:cfswop:200832

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Keywords: Realized Volatility; Market Microstructure Theory; High-Frequency Data; Financial econometrics;

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References

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Citations

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Cited by:
  1. Kim Christensen & Silja Kinnebrock & Mark Podolskij, 2009. "Pre-averaging estimators of the ex-post covariance matrix in noisy diffusion models with non-synchronous data," CREATES Research Papers 2009-45, School of Economics and Management, University of Aarhus.
  2. Goettler, Ronald L. & Parlour, Christine A. & Rajan, Uday, 2009. "Informed traders and limit order markets," Journal of Financial Economics, Elsevier, Elsevier, vol. 93(1), pages 67-87, July.
  3. Kim Christensen & Roel Oomen & Mark Podolskij, 2009. "Realised Quantile-Based Estimation of the Integrated Variance," CREATES Research Papers 2009-27, School of Economics and Management, University of Aarhus.
  4. O. E. Barndorff-Nielsen & P. Reinhard Hansen & A. Lunde & N. Shephard, 2009. "Realized kernels in practice: trades and quotes," Econometrics Journal, Royal Economic Society, Royal Economic Society, vol. 12(3), pages C1-C32, November.
  5. E. Bacry & S. Delattre & M. Hoffmann & J. F. Muzy, 2013. "Modelling microstructure noise with mutually exciting point processes," Quantitative Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 13(1), pages 65-77, January.

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