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On the Correlation Structure of Microstructure Noise: A Financial Economic Approach

  • Francis X. Diebold
  • Georg Strasser

We 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. 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 regarding improved volatility estimation methods.

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File URL: http://www.nber.org/papers/w16469.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16469.

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Date of creation: Oct 2010
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Publication status: published as Francis X. Diebold & Georg Strasser, 2013. "On the Correlation Structure of Microstructure Noise: A Financial Economic Approach," Review of Economic Studies, Oxford University Press, vol. 80(4), pages 1304-1337.
Handle: RePEc:nbr:nberwo:16469
Note: AP EFG IFM
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  1. Hansen, Peter R. & Lunde, Asger, 2006. "Realized Variance and Market Microstructure Noise," Journal of Business & Economic Statistics, American Statistical Association, vol. 24, pages 127-161, April.
  2. Ole E. Barndorff-Nielsen & Peter R. Hansen & Asger Lunde & Neil Shephard, 2006. "Subsampling realised kernels," OFRC Working Papers Series 2006fe06, Oxford Financial Research Centre.
  3. Neil Shephard & Ole E. Barndorff-Nielsen, 2002. "Estimating quadratic variation using realised variance," Economics Series Working Papers 2001-W20, University of Oxford, Department of Economics.
  4. Ole E. Barndorff-Nielsen & Neil Shephard, 2000. "Econometric analysis of realised volatility and its use in estimating stochastic volatility models," Economics Papers 2001-W4, Economics Group, Nuffield College, University of Oxford, revised 05 Jul 2001.
  5. Easley, David & O'Hara, Maureen, 1987. "Price, trade size, and information in securities markets," Journal of Financial Economics, Elsevier, vol. 19(1), pages 69-90, September.
  6. Anderson, Torben G. & Bollerslev, Tim & Diebold, Francis X. & Labys, Paul, 2002. "Modeling and Forecasting Realized Volatility," Working Papers 02-12, Duke University, Department of Economics.
  7. F. M. Bandi & J. R. Russell, 2008. "Microstructure Noise, Realized Variance, and Optimal Sampling," Review of Economic Studies, Oxford University Press, vol. 75(2), pages 339-369.
  8. Nour Meddahi, 2002. "A theoretical comparison between integrated and realized volatility," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 17(5), pages 479-508.
  9. Ait-Sahalia, Yacine & Mykland, Per A. & Zhang, Lan, 2005. "Ultra high frequency volatility estimation with dependent microstructure noise," Discussion Paper Series 1: Economic Studies 2005,30, Deutsche Bundesbank, Research Centre.
  10. Ole E. Barndorff-Nielsen & Peter Reinhard Hansen & Asger Lunde & Neil Shephard, 2008. "Multivariate realised kernels: consistent positive semi-definite estimators of the covariation of equity prices with noise and non-synchronous trading," OFRC Working Papers Series 2008fe29, Oxford Financial Research Centre.
  11. Engle, Robert F. & Patton, Andrew J., 2004. "Impacts of trades in an error-correction model of quote prices," Journal of Financial Markets, Elsevier, vol. 7(1), pages 1-25, January.
  12. Andersen, Torben G. & Bollerslev, Tim & Christoffersen, Peter F. & Diebold, Francis X., 2006. "Volatility and Correlation Forecasting," Handbook of Economic Forecasting, Elsevier.
  13. Foster, F Douglas & Viswanathan, S, 1996. " Strategic Trading When Agents Forecast the Forecasts of Others," Journal of Finance, American Finance Association, vol. 51(4), pages 1437-78, September.
  14. Ole E Barndorff-Nielsen & Peter Hansen & Asger Lunde & Neil Shephard, 2006. "Designing realised kernels to measure the ex-post variation of equity prices in the presence of noise," OFRC Working Papers Series 2006fe05, Oxford Financial Research Centre.
  15. John Owens & Douglas G. Steigerwald, 2005. "Inferring Information Frequency and Quality," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 3(4), pages 500-524.
  16. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
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