On the Correlation Structure of Microstructure Noise: A Financial Economic Approach
73 Pages Posted: 27 Aug 2013
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On the Correlation Structure of Microstructure Noise: A Financial Economic Approach
On the Correlation Structure of Microstructure Noise: A Financial Economic Approach
Date Written: April 24, 2012
Abstract
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 crosscorrelations 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 volatility estimation.
Keywords: Realized volatility, Market microstructure theory, High-frequency data, Financial econometrics
JEL Classification: G14, G20, D82, D83, C51
Suggested Citation: Suggested Citation
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