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

Francis Diebold and Georg Strasser

No 693, Boston College Working Papers in Economics from Boston College Department of Economics

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 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.

Keywords: Realized volatility; Market microstructure theory; High-frequency data; Financial econometrics (search for similar items in EconPapers)
JEL-codes: C51 D82 D83 G14 G20 (search for similar items in EconPapers)
Date: 2008-10-09, Revised 2012-04-24
New Economics Papers: this item is included in nep-ecm, nep-ets, nep-mst and nep-upt
Note: previously circulated as "On the Correlation Structure of Microstructure Noise in Theory and Practice"
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

Published, Review of Economic Studies, 80:4, 1304-1337

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Related works:
Journal Article: On the Correlation Structure of Microstructure Noise: A Financial Economic Approach (2013)
Working Paper: On the Correlation Structure of Microstructure Noise: A Financial Economic Approach (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:boc:bocoec:693

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