On the correlation structure of microstructure noise in theory and practice

Francis Diebold and Georg Strasser

No 2008/32, CFS Working Paper Series from Center for Financial Studies (CFS)

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 cross-correlation 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)
Date: 2008
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Citations: View citations in EconPapers (8)

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Working Paper: On the Correlation Structure of Microstructure Noise in Theory and Practice (2008)
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:cfswop:200832

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