The Latent Factor VAR Model: Testing for a Common Component in the Intraday Trading Process
University of Copenhagen Working Paper No. 2005/03
37 Pages Posted: 14 Jun 2005
Date Written: March 22, 2005
In this paper, we propose a framework for the modelling of multivariate dynamic processes which are driven by an unobservable common autoregressive component. Economically motivated by the mixture-of-distribution hypothesis, we model the multivariate intraday trading process of return volatility, volume and trading intensity by a VAR model that is augmented by a joint latent factor serving as a proxy for the unobserved information flow. The model is estimated by simulated maximum likelihood using efficient importance sampling techniques. Analyzing intraday data from the NYSE, we find strong empirical evidence for the existence of an underlying persistent component as an important driving force of the trading process. It is shown that the inclusion of the latent factor clearly improves the goodness-of-fit of the model as well as its dynamical and distributional properties.
Keywords: Observation vs. parameter driven dynamics, mixture-of-distribution hypothesis, VAR model
JEL Classification: C15, C32, C52
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