A Simple Microstructure Return Model Explaining Microstructure Noise and Epps Effects

Didier Sornette and Alexander I. Saichev
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Didier Sornette: Swiss Finance Institute and ETH Zürich
Alexander I. Saichev: ETH Zürich

No 12-08, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We present a simple microstructure model of financial returns that combines (i) the well-known ARFIMA process applied to tick-by-tick returns, (ii) the bid-ask bounce effect, (iii) the fat tail structure of the distribution of returns and (iv) the non-Poissonian statistics of intertrade intervals. This model allows us to explain both qualitatively and quantitatively important stylized facts observed in the statistics of microstructure returns, including the short-ranged correlation of returns, the long-ranged correlations of absolute returns, the microstructure noise and Epps effects. According to the microstructure noise effect, volatility is a decreasing function of the time scale used to estimate it. Paradoxically, the Epps effect states that cross correlations between asset returns are increasing functions of the time scale at which the returns are estimated. The microstructure noise is explained as the result of the negative return correlations inherent in the definition of the bid-ask bounce component (ii). In the presence of a genuine correlation between the returns of two assets, the Epps effect is due to an average statistical overlap of the momentum of the returns of the two assets defined over a finite time scale in the presence of the long memory process (i).

Keywords: high-frequency trading; micro-structure; Epps effect; long memory; momentum (search for similar items in EconPapers)
JEL-codes: C32 G17 (search for similar items in EconPapers)
Pages: 53 pages
Date: 2012-02
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1208

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