Working Paper: NBER ID: w16469
Authors: Francis X. Diebold; Georg Strasser
Abstract: 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.
Keywords: market microstructure; volatility estimation; latent prices; microstructure noise
JEL Codes: C51; D82; D83; G14; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| latent prices (strong form) (D84) | microstructure noise (MSN) (C58) |
| latent prices (semistrong) (D84) | microstructure noise (MSN) (C58) |
| market makers' risk aversion (D81) | cross-correlation between latent returns and MSN (C29) |
| stronger market return's volatility (G17) | contemporaneous cross-correlation positive (C10) |
| microstructure noise (C58) | biased estimates of variance of efficient returns (C51) |
| latent prices (J46) | biased estimates of variance of efficient returns (C51) |