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Title:On the correlation structure of microstructure noise in theory and practice PDF Logo
Authors:Diebold, Francis X.
Strasser, Georg H.
Issue Date:2008
Series/Report no.:CFS Working Paper 2008/32
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.
Subjects:Realized Volatility
Market Microstructure Theory
High-Frequency Data
Financial econometrics
JEL:G14
G20
D82
D83
C51
Persistent Identifier of the first edition:urn:nbn:de:hebis:30-58883
Document Type:Working Paper
Appears in Collections:CFS Working Paper Series, Universität Frankfurt a. M.

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