A simple microstructure return model explaining microstructure noise and Epps effects

A. Saichev and D. Sornette ()
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A. Saichev: Department of Management, ETH Zurich Technology and Economics, Scheuchzerstrasse 7, CH-8092 Zurich, Switzerland;
D. Sornette: Department of Management, ETH Zurich Technology and Economics, Scheuchzerstrasse 7, CH-8092 Zurich, Switzerland;

International Journal of Modern Physics C (IJMPC), 2014, vol. 25, issue 06, 1-36

Abstract: We present a novel 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 inter-trade intervals. This model allows us to explain both qualitatively and quantitatively important stylized facts observed in the statistics of both microstructure and macrostructure 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. 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; JEL Classification: C32; JEL Classification: G17 (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (4)

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DOI: 10.1142/S0129183114500120

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