TY - JOUR AU - Diebold, Francis X AU - Strasser, Georg TI - On the Correlation Structure of Microstructure Noise: A Financial Economic Approach JF - National Bureau of Economic Research Working Paper Series VL - No. 16469 PY - 2010 Y2 - October 2010 DO - 10.3386/w16469 UR - http://www.nber.org/papers/w16469 L1 - http://www.nber.org/papers/w16469.pdf N1 - Author contact info: Francis X. Diebold Department of Economics University of Pennsylvania 133 South 36th Street Philadelphia, PA 19104-6297 Tel: 215/898-1507 Fax: 212/573-4217 E-Mail: fdiebold@sas.upenn.edu Georg Strasser Research Department Europe E-Mail: Georg.Strasser@ecb.europa.eu AB - 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. ER -