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Elements of Volatility at High Frequency

Elements of Volatility at High Frequency

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Vuorenmaa, Tommi A. (2008). “Elements of Volatility at High Frequency” Doctoral Dissertation, Kansantaloustieteen laitoksen tutkimuksia, No. 111:2008, Helsinki, July 4, 2008

This doctoral dissertation focuses on financial econometrics and, more specifically, on time series methods that can be used to analyze stock market data observed with a very high frequency within a day. The use of such ultra-high-frequency data is common to all three essays of the dissertation. The first essay uses wavelet methods to study the time-varying behavior of scaling laws and long-memory in the five-minute volatility series of Nokia Oyj at the Helsinki Stock Exchange (HSE) around the burst of the “IT-bubble”. The essay is motivated by earlier findings which suggest that different scaling factors may apply to intraday time-scales and to larger timescales. The empirical results confirm the appearance of time varying long-memory and different scaling factors that, for a significant part, can be attributed to an intraday volatility periodicity called the “New York effect”. The second essay investigates modeling the duration between trades in stock markets. Generalizations of standard autoregressive conditional duration models (ACD) are developed to meet needs observed in previous applications of the standard models. According to empirical results based on data from the New York Stock Exchange (NYSE) and the Helsinki Stock Exchange the proposed generalization clearly outperforms the standard models and also performs well in comparison with another recently proposed alternative to the standard models. The third essay studies empirically the effect of decimalization both on volatility and market microstructure noise. Decimalization refers to the change from fractional pricing to decimal pricing that was carried out in the New York Stock Exchange in January, 2001. The main result of the essay is that decimalization decreased observed volatility by reducing noise variance especially for the highly active stocks.
Vuorenmaa, Tommi A. (2008). “Elements of Volatility at High Frequency” Doctoral Dissertation, Kansantaloustieteen laitoksen tutkimuksia, No. 111:2008, Helsinki, July 4, 2008

This doctoral dissertation focuses on financial econometrics and, more specifically, on time series methods that can be used to analyze stock market data observed with a very high frequency within a day. The use of such ultra-high-frequency data is common to all three essays of the dissertation. The first essay uses wavelet methods to study the time-varying behavior of scaling laws and long-memory in the five-minute volatility series of Nokia Oyj at the Helsinki Stock Exchange (HSE) around the burst of the “IT-bubble”. The essay is motivated by earlier findings which suggest that different scaling factors may apply to intraday time-scales and to larger timescales. The empirical results confirm the appearance of time varying long-memory and different scaling factors that, for a significant part, can be attributed to an intraday volatility periodicity called the “New York effect”. The second essay investigates modeling the duration between trades in stock markets. Generalizations of standard autoregressive conditional duration models (ACD) are developed to meet needs observed in previous applications of the standard models. According to empirical results based on data from the New York Stock Exchange (NYSE) and the Helsinki Stock Exchange the proposed generalization clearly outperforms the standard models and also performs well in comparison with another recently proposed alternative to the standard models. The third essay studies empirically the effect of decimalization both on volatility and market microstructure noise. Decimalization refers to the change from fractional pricing to decimal pricing that was carried out in the New York Stock Exchange in January, 2001. The main result of the essay is that decimalization decreased observed volatility by reducing noise variance especially for the highly active stocks.

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11/28/2012

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The academicly literate routinely hold that stock prices are governed by their prospective

future payo s. In discrete time this can be stated as

E 1 =E 1

X =0

+

(1 + + )

(1.1)

where is the value of the stock, is the discount rate, are the future dividends, and

E 1 represents the conditional expectation on information available at time 1 This

valuation formula implies that the volatility (variance) of the stock price, V 1 depends

on the conditional variances of future dividends and discount factors and their conditional

covariances. Shiller (1981) shows, however, that the dividends process is not volatile enough

to explain the behavior of observed stock market volatility over time. Although the variance

bound method used by him may be criticized [see Kleidon (1986)], Schwert (1989) provides

supporting evidence for his argument by showing that stock market volatility is not closely

related to other measures of economic volatility such as inflation or money growth volatility.

Moreover, although macroeconomic news announcements can significantly a ect the future

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prospects of a company and the discount factor, most of the empirical evidence shows that

their e ect is quite well forecastable and typically relatively small and temporary, as demon-

strated in the first essay [see also, e.g., Ederington and Lee (1993)]. Finally, it is doubtful

that macroeconomic and company specific news would bunch together enough to explain

the behavior of volatility [see, e.g., Engle, Ito, and Lin (1990)]. As a resolution to why

stock market volatility is in practice so high without no obvious rational reason, Timmer-

mann (2001) suggests that structural breaks (i.e., low-frequency events which introduce level

shifts) in the dividend process would cause volatility clustering through a recursive learning

process. This then leads us to the role of asymmetry of information and market sentiment.

In his classic book "The General Theory of Employment, Interest and Money," Keynes

stresses the role of expectations of other investors’ expectations and "animal spirits" (irra-

tionality of the investors). It is Keynes who the famous and timely quote "the market can

stay irrational longer than you can stay solvent" is commonly attributed to. Such a para-

digm gets support from the well-known game theoretical example demonstrating that given

no obvious model for people to follow, if everybody make their decision rationally based on

just what they expect others to do and nobody knows more than the others, then there is

no well defined rational equilibrium [see Arthur (1994)]. Moreover, in financial economics,

Wang (1993) shows that asymmetric information about the future dividend growth rate can

create more volatility than rational expectations can. These are evidence against rationality.

It is often suggested that information flow can be proxied by trading volume which,

according to Jones, Kaul, and Lipson (1994), reflects the number of transactions rather

than their size. A positive relationship between volume and volatility is reported by many

authors [see Karpo (1987) for a review]. Such a relationship could be interpreted as a

sign of a common origin. Tauchen and Pitts (1983), for example, model both variables as

dependent on (i) the average daily rate at which new information flows to the market; (ii)

the extent to which traders disagree when they respond to new information; and (iii) the

number of active traders in the market. The second factor reflects information asymmetry

through the heterogenuity of the agents. Similarly, in econophysics (economics seen from

physicists’ perspective), heterogenous agent models have been shown to create volatility

clustering due to herding [see, e.g., Wagner (2003)]. Naturally there may also exist some

other enforcing factors such as self-fulfilling prophecies [see Demetrescu (2007)], but the

central role of asymmetric information, heterogenuity, and animal spirits is hard to dispute.

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