New Economics Papers
on Market Microstructure
Issue of 2007‒06‒11
three papers chosen by
Thanos Verousis

  1. Does the Option Market Produce Superior Forecasts of Noise-Corrected Volatility Measures? By Gael M. Martin; Andrew Reidy; Jill Wright
  2. On the Interaction between Ultra–high Frequency Measures of Volatility By Giampiero Gallo; Margherita Velucchi
  3. Exchange Rate Fundamentals and Order Flow By Martin D. D. Evans; Richard K. Lyons

  1. By: Gael M. Martin; Andrew Reidy; Jill Wright
    Abstract: This paper presents a comprehensive empirical evaluation of option-implied and returns-based forecasts of volatility, in which recent developments related to the impact on measured volatility of market microstructure noise are taken into account. The paper also assesses the robustness of the performance of the option-implied forecasts to the way in which those forecasts are extracted from the option market. Using a test for superior predictive ability, model-free implied volatility, which aggregates information across the volatility 'smile', and at-the-money implied volatility, which ignores such information, are both tested as benchmark forecasts. The forecasting assessment is conducted using intraday data for three Dow Jones Industrial Average (DJIA) stocks and the S&P500 index over the 1996-2006 period, with future volatility proxied by a range of alternative noise-corrected realized measures. The results provide compelling evidence against the model-free forecast, with its poor performance linked to both the bias and excess variability that it exhibits as a forecast of actual volatility. The positive bias, in particular, is consistent with the option market factoring in a substantial premium for volatility risk. In contrast, implied volatility constructed from liquid at-the-money options is given strong support as a forecast of volatility, at least for the DJIA stocks. Neither benchmark is supported for the S&P500 index. Importantly, the qualitative results are robust to the measure used to proxy future volatility, although there is some evidence to suggest that any option-implied forecast may perform less well in forecasting the measure that excludes jump information, namely bi-power variation.
    Keywords: Volatility Forecasts; Quadratic Variation; Intraday Volatility Measures
    JEL: C10 C53 G12
    Date: 2007–06
  2. By: Giampiero Gallo (Università degli Studi di Firenze, Dipartimento di Statistica "G. Parenti"); Margherita Velucchi (Università degli Studi di Firenze, Dipartimento di Statistica)
    Abstract: We analyze several measures of volatility (realized variance, bipower variation and squared daily returns) as estimators of integrated variance of a continuous time stochastic process for an asset price. We use a Multiplicative Error Model to describe the evolution of each measure as the product of its conditional expectation and a positive valued iid innovation. By inserting past values of each measure and asymmetric effects based on the sign of the return in the specification of the conditional expectation, one can investigate the information content of each indicator relative to the others. The results show that there is a directed dynamic relationship among measures, with squared returns and bipower variance interdependent with one another, and affecting realized variance without any feed-back from the latter.
    Keywords: Volatility, Multiplicative Error Models, Realized Variance, Bi-power Variance, Squared Returns, Jumps.
    JEL: C22 C51 C53
    Date: 2007–05
  3. By: Martin D. D. Evans; Richard K. Lyons
    Abstract: We address whether transaction flows in foreign exchange markets convey fundamental information. Our GE model includes fundamental information that first manifests at the micro level and is not symmetrically observed by all agents. This produces foreign exchange transactions that play a central role in information aggregation, providing testable links between transaction flows, exchange rates, and future fundamentals. We test these links using data on all end-user currency trades received at Citibank over 6.5 years, a sample sufficiently long to analyze real-time forecasts at the quarterly horizon. The predictions are borne out in four empirical findings that define this paper's main contribution: (1) transaction flows forecast future macro variables such as output growth, money growth, and inflation, (2) transaction flows forecast these macro variables significantly better than the exchange rate does, (3) transaction flows (proprietary) forecast future exchange rates, and (4) the forecasted part of fundamentals is better at explaining exchange rates than standard measured fundamentals.
    JEL: F31 G12 G14
    Date: 2007–06

This issue is ©2007 by Thanos Verousis. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.