LIFE Working Paper 04 – 008 “ Realized Variance in the Presence of non - IID Microstructure Noise

It is a well known fact that at high sampling frequencies, the contamination of microstructure noise causes the Realized Variance to be a biased measure of the Integrated Variance. Recent developments in this field propose sampling on lower frequencies, sub-sampling techniques, or bias corrections using the autocorrelation patterns in the data. In this paper we propose a structural decomposition of the efficient price process and the microstructure noise. In this decomposition we allow for potential correlation between the efficient price and the microstructure noise. We apply this decomposition to 20 actively traded stocks at Nasdaq. Our results suggest that ignoring this correlation leads to an upward bias in the Realized Variance. As our model is designed for ultra-high frequency data, we can study the impact of time between transaction on the evolution of the efficient price and on the correlation between the microstructure noise and the efficient price.