Local Mispricing and Microstructural Noise: A Parametric Perspective
46 Pages Posted: 23 Feb 2017 Last revised: 29 Sep 2020
Date Written: July 24, 2020
We extend the classic ''martingale-plus-noise'' model for high-frequency returns to accommodate an error correction mechanism and endogenous pricing errors. It is motivated by (i) novel empirical evidence documenting that microstructure noise exhibits frequently changing patterns of serial dependence and is interwoven with innovations to the efficient price; (ii) building a bridge between high-frequency econometrics and market microstructure models. We identify temporal pricing error corrections and noise endogeneity as complementary components driving high-frequency dynamics and inducing two separate regimes, characterized by the sign of the return serial correlation and an implied bias in realized variance estimates. We document frequent fluctuations between these regimes, which can be associated with price discovery in a setting with incomplete information and learning. The model links critical concepts from high-frequency statistics and market microstructure theory, suggesting new avenues for volatility estimation.
Keywords: Volatility estimation; market microstructure noise; price reversal; momentum trading; contrarian trading
JEL Classification: C58, C32, G14
Suggested Citation: Suggested Citation