On the Correlation Structure of Microstructure Noise in Theory and Practice

Francis Diebold and Georg Strasser

PIER Working Paper Archive from Penn Institute for Economic Research, Department of Economics, University of Pennsylvania

Abstract: 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.

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)
Pages: 68 pages
Date: 2008-10-09
New Economics Papers: this item is included in nep-ecm, nep-ets, nep-mst and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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Working Paper: On the correlation structure of microstructure noise in theory and practice (2008)
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