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

Francis X. Diebold, Georg Strasser

NBER Working Paper No. 16469
Issued in October 2010
NBER Program(s):   AP   EFG   IFM

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. 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 regarding improved volatility estimation methods.

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Acknowledgments

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