New Economics Papers
on Market Microstructure
Issue of 2006‒08‒05
nine papers chosen by
Thanos Verousis

  1. Ultra high frequency volatility estimation with dependent microstructure noise By Ait-Sahalia, Yacine; Mykland, Per A.; Zhang, Lan
  2. What drives volatility persistence in the foreign exchange market? By David Berger; Alain Chaboud; Erik Hjalmarsson; Edward Howorka
  3. Transmission of volatility and trading activity in the global interdealer foreign exchange market: evidence from electronic broking services (EBS) data By Fang Cai; Edward Howorka; Jon Wongswan
  4. Search in asset markets By Ricardo Lagos; Guillaume Rocheteau
  5. Testing Temporal Disaggregation By Christian Müller
  6. The coordination channel of foreign exchange intervention: a nonlinear microstructural analysis By Reitz, Stefan; Taylor, Mark P.
  7. Fool the Markets? Creative Accounting, Fiscal Transparency and Sovereign Risk Premia By Kerstin Bernoth; Guntram B. Wolff
  8. The forecast ability of risk-neutral densities of foreign exchange By Craig, Ben; Keller, Joachim
  9. A Noise Trader Model as a Generator of Apparent Financial Power Laws and Long Memory By Alfarano, Simone; Lux, Thomas

  1. By: Ait-Sahalia, Yacine; Mykland, Per A.; Zhang, Lan
    Abstract: We analyze the impact of time series dependence in market microstructure noise on the properties of estimators of the integrated volatility of an asset price based on data sampled at frequencies high enough for that noise to be a dominant consideration. We show that combining two time scales for that purpose will work even when the noise exhibits time series dependence, analyze in that context a refinement of this approach based on multiple time scales, and compare empirically our different estimators to the standard realized volatility.
    Keywords: Market microstructure, Serial dependence, High frequency data, Realized volatility, Subsampling, Two Scales Realized Volatility
    Date: 2005
  2. By: David Berger; Alain Chaboud; Erik Hjalmarsson; Edward Howorka
    Abstract: We analyze the factors driving the widely-noted persistence in asset return volatility using a unique dataset on global euro-dollar exchange rate trading. We propose a new simple empirical specification of volatility, based on the Kyle-model, which links volatility to the information flow, measured as the order flow in the market, and the price sensitivity to that information. Through the use of high-frequency data, we are able to estimate the time-varying market sensitivity to information, and movements in volatility can therefore be directly related to movements in two observable variables, the order flow and the market sensitivity. The empirical results are very strong and show that the model is able to explain almost all of the long-run variation in volatility. Our results also show that the variation over time of the market's sensitivity to information plays at least as important a role in explaining the persistence of volatility as does the rate of information arrival itself. The econometric analysis is conducted using novel estimation techniques which explicitly take into account the persistent nature of the variables and allow us to properly test for long-run relationships in the data.
    Keywords: Foreign exchange rates ; Foreign exchange market
    Date: 2006
  3. By: Fang Cai; Edward Howorka; Jon Wongswan
    Abstract: This paper studies the transmission of volatility and trading activity in the foreign exchange market across trading regions for the euro-dollar and dollar-yen currency pairs, using high-frequency intraday data from Electronic Broking Services (EBS). In contrast with previous studies that use indicative quote frequency to proxy for trading activity, we use actual regional trading volume to identify five distinct trading regions in the foreign exchange market: Asia Pacific, the Asia-Europe overlap, Europe, the Europe-America overlap, and America. Based on realized volatility computed from high-frequency data and a regional volatility model, we find statistically significant evidence for volatility spillovers at both the own-region and the inter-region levels, but the economic significance of own-region spillovers is much more important than that of inter-region spillovers. We also examine the transmission of trading activity (trading volume and number of transactions) across the five trading regions and find similar results to those for volatility, but the economic significance of own-region spillovers is even more dominant.
    Keywords: Foreign exchange rates ; International finance
    Date: 2006
  4. By: Ricardo Lagos; Guillaume Rocheteau
    Abstract: We investigate how trading frictions in asset markets affect portfolio choices, asset prices and efficiency. We generalize the search-theoretic model of financial intermediation of Duffie, Gârleanu and Pedersen (2005) to allow for more general preferences and idiosyncratic shock structure, unrestricted portfolio choices, aggregate uncertainty and entry of dealers. With a fixed measure of dealers, we show that a steady-state equilibrium exists and is unique, and provide a condition on preferences under which a reduction in trading frictions leads to an increase in the price of the asset. We also analyze the effects of trading frictions on bid-ask spreads, trade volume and the volatility of asset prices, and find that the asset allocation is constrained-inefficient unless investors have all the bargaining power in bilateral negotiations with dealers. We show that the dealers’ entry decision introduces a feedback that can give rise to multiple equilibria, and that free-entry equilibria are generically inefficient.
    Date: 2006
  5. By: Christian Müller (Swiss Institute for Business Cycle Research (KOF), Swiss Federal Institute of Technology Zurich (ETH))
    Abstract: Economists and econometricians very often work with data which has been temporally disaggregated prior to use. Hence, the quality of the disaggregation clearly aspects the qual- ity of the analyses. Building on Chow and Lin's (1971) disaggregation model this paper proposes a new estimation approach and a specification test which assesses the quality of the disaggregation model. An advantage of the proposal is that estimation and testing can both be pursued using the aggregated data while the standard method requires a mixture of high and low frequency data. A small simulation study shows that the test indeed provides useful information.
    Keywords: temporal disaggregation, restricted ARMA
    JEL: F31 F47 C53
    Date: 2006–04
  6. By: Reitz, Stefan; Taylor, Mark P.
    Abstract: The coordination channel has been proposed as a means by which foreign exchange market intervention may be effective, in addition to the traditional portfolio balance and signaling channels. If strong and persistent misalignments of the exchange rate are caused by non-fundamental influences, such that a return to equilibrium is hampered by a coordination failure among fundamentals-based traders, then central bank intervention may act as a coordinating signal, encouraging stabilizing speculators to re-enter the market at the same time. We develop this idea in the framework of a simple microstructural model of exchange rate movements, which we then estimate using daily data on the dollar-mark exchange rate and on Federal Reserve and Bundesbank intervention operations. The results are supportive of the existence of a coordination channel of intervention effectiveness.
    Keywords: foreign exchange intervention, coordination channel, market microstructure, nonli mean reversion
    JEL: C10 F31 F41
    Date: 2006
  7. By: Kerstin Bernoth; Guntram B. Wolff
    Abstract: We investigate the effects of official fiscal data and creative accounting signals on interest rate spreads between bond yields in the European Union. Our model predicts that risk premia contained in government bond spreads should increase in both the official fiscal position and the expected “creative” part of fiscal policy. The relative importance of these two signals depends on the transparency of the country. Greater transparency reduces risk premia. The empirical results confirm the hypotheses. Creative accounting increases the spread. The increase of the risk premium is stronger if financial markets are unsure about the true extent of creative accounting. Fiscal transparency reduces risk premia.
    Keywords: risk premia, government bond yields, creative accounting, stock-flow adjustments, gimmickry, transparency
    JEL: E43 E62 F34 G12 H60
    Date: 2006
  8. By: Craig, Ben; Keller, Joachim
    Abstract: We estimate the process underlying the pricing of American options by using higher-order lattices combined with a multigrid method. This paper also tests whether the risk-neutral densities given from American options provide a good forecasting tool. We use a nonparametric test of the densities that is based on the inverse probability functions and is modified to account for correlation across time between our random variables, which are uniform under the null hypothesis. We find that the densities based on the Americanoption markets for foreign exchange do quite well for the forecasting period over which the options are thickly traded. Further, simple models that fit the densities do about as well as more sophisticated models. Keywords: Risk-neutral densities from option prices, American exchange rate options, Evaluating Density Forecasts, Pentionominal tree, Density evaluation, Overlapping data problem
    Keywords: Risk-neutral densities from option prices, American exchange rate options, Evaluating Density Forecasts, Pentionominal tree, Density evaluation
    JEL: C52 C63 F31 F47
    Date: 2005
  9. By: Alfarano, Simone; Lux, Thomas
    Abstract: In various agent-based models the stylized facts of financial markets (unit-roots, fat tails and volatility clustering) have been shown to emerge from the interactions of agents. However, the complexity of these models often limits their analytical accessibility. In this paper we show that even a very simple model of a financial market with heterogeneous interacting agents is capable of reproducing these ubiquitous statistical properties. The simplicity of our approach permits to derive some analytical insights using concepts from statistical mechanics. In our model, traders are divided into two groups: fundamentalists and chartists, and their interactions are based on a variant of the herding mechanism introduced by Kirman [1993]. The statistical analysis of simulated data points toward long-term dependence in the auto-correlations of squared and absolute returns and hyperbolic decay in the tail of the distribution of raw returns, both with estimated decay parameters in the same range like those of empirical data. Theoretical analysis, however, excludes the possibility of ‘true’ scaling behavior because of the Markovian nature of the underlying process and the boundedness of returns. The model, therefore, only mimics power law behavior. Similarly as with the phenomenological volatility models analyzed in LeBaron [2001], the usual statistical tests are not able to distinguish between true or pseudo-scaling laws in the dynamics of our artificial market.
    Keywords: Herd Behavior ; Speculative Dynamics ; Fat Tails ; Volatility Clustering
    JEL: C61 G12
    Date: 2005

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