#08-36
On the Correlation Structure of Microstructure Noise in Theory and Practice
Francis X. Diebold and Georg H. Strasser, October 2008
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 crosscorrelation 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
JEL classifications: G14, G20, D82, D83, C51
