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Frequency domain estimation of integrated volatility for Ito processes in the presence of market-microstructure noise

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<mark>Journal publication date</mark>2009
<mark>Journal</mark>Multiscale Modeling and Simulation
Issue number2
Volume8
Number of pages35
Pages (from-to)393-427
Publication statusPublished
Original languageEnglish

Abstract

This paper proposes a novel multiscale estimator for the integrated volatility of an Ito process in the presence of market microstructure noise (observation error). The multiscale structure of the observed process is represented frequency by frequency, and the concept of the multiscale ratio is introduced to quantify the bias in the realized integrated volatility due to the observation error. The multiscale ratio is estimated from a single sample path, and a frequency-by-frequency bias correction procedure is proposed, which simultaneously reduces variance. We extend the method to include correlated observation errors and provide the implied time-domain form of the estimation procedure. The new method is implemented to estimate the integrated volatility for the Heston and other models, and the improved performance of our method over existing methods is illustrated by simulation studies.