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On the Correlation Structure of Microstructure Noise in Theory and Practice

  • Francis X. Diebold

    ()

    (Department of Economics, University of Pennsylvania)

  • Georg H. Strasser

    ()

    (Department of Economics, Boston College)

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 crosscorrelation patterns, for predicting as-yet undiscovered patterns, and for making informed conjectures as to improved volatility estimation methods.

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File URL: http://economics.sas.upenn.edu/system/files/working-papers/08-038.pdf
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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 08-038.

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Length: 68 pages
Date of creation: 09 Oct 2008
Date of revision:
Handle: RePEc:pen:papers:08-038
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