On the Correlation Structure of Microstructure Noise in Theory and Practice

Joint with: Francis X. Diebold

We use market microstructure theory to derive the cross-correlation function between latent returns and market microstructure noise. The cross-correlation at zero displacement is typically negative, and cross-correlations at nonzero displacements are positive and decay geometrically. When market makers are very risk averse, the cross-correlation pattern is inverted. The results may be useful for choosing among different market microstructure models and estimation of noise-robust measures of realized volatility.

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