Forecasting Volatility Using Tick by Tick Data

Robert Engle Zheng Sun

Department of Finance Department of Finance

Stern School of Business Stern School of Business

New York University New York University

Abstract

The paper builds an econometric model for estimating the volatility of unobserved

e¢ cient price change using tick by tick data. We model the joint density of the marked

point process of duration and tick by tick returns within an ACD-GARCH framework.

We …rst model the duration variable as an ACD process that could potentially depend

on past returns. We then model the return variable conditioning on its current duration

as well as past information. The observed return process admits a state space model,

where the unobserved e¢ cient price innovation and microstructure noises serve as state

variables. After adjusting for bid-ask spread and a non-linear function of durations,

tick by tick returns are distributed independently of durations, with volatility that

admits a GARCH process. We apply the above model to frequently traded NYSE stock

transactions data. It appears that contemporaneous duration has little a¤ect on the

conditional volatility per trade, which means per second volatility is inversely related

to the duration between trades. This is consistent with the result of Engle (2000) and

Easley and O’Hara (1987). The model is used to obtain a new, model-based estimate

of daily, realized volatility as well as the volatility of e¢ cient price changes.Volatility is

forecasted over calendar time intervals by simulation. The distribution of the number

of trades is central in forming these forecasts.

1
1 Introduction

Ultra-high frequency data include records of all transactions and their characteristics. These
data encompass most public information that economists can use to model the time series
of …nancial variables such as price, return, etc. An important feature of …nancial markets is
that transactions occur at irregularly-spaced times. Duration between trades and price are
jointly determined by the amount of news in the market, so that they might be correlated.
Therefore, estimators for one of the variables conditional on the other will be more e¢ cient
than those without. This motivates us to build an econometric model that incorporates
the duration information in forecasting volatility of returns. While theoretical economists
have long pointed out the important price implication of trading duration [Lo and MacKin-
lay(1990), Easley and O’Hara(1992), Diamond and Verrecchia(1987)], this feature is largely
ignored when an econometric model need to be built. For example, transactions data are
usually converted into …xed-time intervals through interpolation or imputation methods.
Although regularly spaced data allow econometrician to apply classical time series method,
there are some drawbacks for such conversions. First, only a subset of the data may be used
if the …xed-length interval is broad. Second, data at time t do not necessarily refer to market
observations at that time,which is the so called non synchronous trading e¤ect [Andrew Lo
and MacKinlay (1990), Scholes and Williams (1977)]. Third, and perhaps most importantly,
converting irregularly spaced data into …xed intervals will lose one important dimension of
information— duration of trades–since the time between transactions often re‡ects, to some
degree, how fast the market adjusts to the news.
One important aspect of trading behavior is how fast investors trade when news comes,
which re‡ects investors’decision making behavior. The trading intensity can be time varying
for each player, and it can also vary among di¤erent type of market players. Factors such
as the direction and magnitude of news, whether the news is public or private, whether a
trader is informed of the news, whether it is a market order or limit order that investors
submit, whether short sales are allowed [Diamond and Verrecchia(1987)] will all play a role

2
in determining the trading frequency of an investor. For example, when an important news
is publicly announced, all the traders will adjust their portfolio as quickly as possible, so that
the news will be incorporated into price almost in no time. On the other hand, if the news is
only private to some investor, they might accelerate their trading frequency in order to take
advantage of the news before the information becomes public. At the same time, given the
increased trading frequency by some informed traders, the rest of the market will have three
possible responses: …rst, they may increase their trading frequency on the same side as the
informed traders so that they can gain some pro…t from following the informed traders, these
traders are likely to be positive feed back traders; second, the adverse selection problem may
keep the uninformed traders staying away from the market, so their trading frequency will
go down[Admati and P‡eiderer (1988)]; and …nally, if the uninformed traders are liquidity
traders, their trading frequency won’t be a¤ected by the news[Easley and O’Hara 1987].
Important as it is, which of the above possibilities are most dominant in the market is not
clear in the literature. In some theoretical analyses, di¤erent implications are derived from
di¤erent assumptions about preferences, endowments and information. In other models, the
behavior is simply assumed. Empirically, it is hard to form a test since econometricians only
observe pooled behavior of all type of players, and they usually don’t observe private news.
However, di¤erent types of trading behaviors will exhibit di¤erent trade clustering and short
term price behaviors, therefore by examining the joint dependence of market price behavior
and trading frequencies, we can draw some indirect inference about investors decision making
process. So far as we know, there has not been much study on this.
The autoregressive conditional duration model (ACD) proposed by Engle and Russell
(1998), which focuses on the time elapsed between the occurrences of trading events, forms a
basis for incorporating trading duration information into the analysis of irregularly –spaced
high frequency data. Basically, they model price change process/return process as a condi-
tional Poisson process where past information only a¤ects waiting time through conditional
mean. Combined with ACD model, Engle (2000) built a UHF-GARCH model of volatility

3
per unit of calendar time, and found that both returns and variances are negatively in‡u-
enced by long durations. Following these seminal work, we model the joint density of the
marked point process of duration and tick by tick returns within an ACD/UHF-GARCH
framework. We …rst model the duration variable as an exogenous ACD process that do not
depend on past returns. We then model the return variable conditioning on its current dura-
tion as well as past information. However, instead of modeling volatility linearly in time, we
try to model return’s volatility as nonlinear functions of durations. Once the distribution of
duration conditional past information (return and duration) and the distribution of return
conditional on current duration and past information are speci…ed, the joint distribution of
return and duration is obtained. Therefore, we could forecast volatility for returns during
any arbitrary length of time.
Standard Market Microstructure theory implies a di¢ culty in forecasting Ultra-high fre-
quency volatilities: unobservability of e¢ cient price induced by the fragility of markets.
For example, the existence of bid-ask spread makes the observed price not the e¢ cient
price, which adds additional volatility to returns. This problem is most serious in the high-
frequency data, since the volatility from bid-ask spread usually doesn’t shrink with time
interval but the volatility from e¢ cient price does[Yacine Alt-Sahalia (2003)]. Therefore, a
volatility forecasting model based on Ultra-high frequency data needs to incorporate this
e¤ect. One common way is to use mid-quotes instead of trade prices; however, this doesn’t
help when one wants to forecast volatility of returns for real transactions. Another way is
to calculate average bid-ask spread across history …rst and then adjust the transaction price
by half of bid-ask spread. Besides the problem with computing average bid-ask spread, the
econometricians usually can’t obtain the information about whether the transaction is buy
order initiated or a sell order initiated, or one between two nonspecialists. So how to adjust
the transaction price is not obvious. Instead of adjusting bid-ask spread, or microstructure
e¤ects in general, before modeling returns, we incorporate the two processes simultaneously
into our model. Speci…cally, we model the observed price process as a sum of the unobserved

4
e¢ cient price and a noise representing frictions potentially due to microstructure e¤ects. We
follow the convention by modeling the e¢ cient price as a martingale process, with condi-
tional volatility of e¢ cient price changes dependent on the duration since the last trade. In
our model for microstructure noise, we don’t specify the origin of market frictions, because
the previous literature has found mixed sources that a¤ect transaction prices.[Stoll(1989),
Huang and Stoll(1997)]. Our model is general enough to encompass most of the sources that
have been studied in the literature. We include two parts of microstructure noise: the …rst
part is the …xed noise potentially due to order processing cost [Roll (1984)] or inventory con-
trol by dealers [(Amihud and Mendelson (1986)]; and the second part is microstructure noise
correlated with the e¢ cient price change, which may come from asymmetric information or
stale prices. The model is estimated using Kalman Filtering.
The paper that is mostly closely related to ours is the one by Frijns and Schotman (2005),
where the authors studies price discovery in tick times. They also use state spaces models
for incorporating microstructure noises into the price processes and treate the volatility
of return as a nonlinear function of duration multiplicative to the volatility of innovation.
However, there are several distinctions between the two papers. First, the two papers try to
answer di¤erent questions, Frijns and Schotman study the information share from di¤erent
markets, so quotes data are used, while our paper models volatility for transaction prices.
Second, volatility was not a focus of the other paper, so it is assumed constant other than
the e¤ect from duration. Our paper builds an more elaborate model on volatility which
incorporate long term and short term persistence of volatility as well as the time of day
e¤ect on it. Third, our speci…cation for microstructure noise is more general than the other
paper, so it is able to encompass a wide range of theoretical microstructure models. And
…nally, the stocks that are studied in our paper are traded on NYSE, while the other paper
uses NASDAQ stocks, since the two markets have very di¤erent trading mechanisms as well
as investor composition, the price-trading intensity relationship could be di¤erent.
There are two main …ndings: …rst, tick by tick volatility is homogeneous of degree 0 to

5
duration, suggesting stationarity in tick time rather than commonly assumed "wall clock"
time. Each trade bares same amount of information, and the total amount of information
determines the number of transactions. Second, the realized volatility for high frequency
data tends to be an upward biased estimate of the volatility of the e¢ cient of price change,
because the observed price is contaminated by the microstructure noise. The percentage of
upward bias varies dramatically from stock to stock, with a median bias of 63.53%. This
suggests it is critical to …lter out microstructure noise if one wants to use high frequency
data for forecasting volatility.
The rest of the paper is organized as follows: Section 2 develops the econometric models
of the joint distribution of returns and durations. Section 3 applies the model to a sample
of NYSE stocks, Section 4 discusses implication for the market microstructure literature.
Section 5 discusses possible extensions of the model and concludes.

2 Model

Suppose we want to use tick by tick data to forecast the volatility of returns over the next
certain period of time T. Let ri be the ith return over the period, and ti be the time of
the ith price change. The duration for return ri is di = ti ti 1 .Then the T-period return
n 1
is simply i=1 ri , where n is the stopping time such that the cumulative duration is bigger
than T for the …rst time. If we assume that ri is covariance stationary and n is …nite almost
surely, r1 ; r2 are i.i.d. and independent of n[Ross (1996)], then we can simply apply Wald’s
theorem to obtain the forecasted volatility of T-period return given all past information F0 ,

n 1
var i=1 ri jF0 = E(n 1jF0 )V ar(r1 jF0 )

However, the characteristics of the operation of …nancial market complicate the problem
in at least two levels. First, the observed high frequency returns will be serially correlated
for the reason implied by the microstructure theory and investors’feedback trading behav-

6
iors. Second, return and duration (thus stopping time) could be interdependent, therefore
the forecasting problem depends on the joint distribution of the marked point process of
durations and tick by tick returns.

f (di ; ri jdei 1 ; rei 1 ; i ) = g(di jdei 1 ; rei 1 ; 1i ) q(ri jdi ; dei 1 ; rei 1 ; 2i ) (1)

where rei 1 is sequence of past returns up to the (i 1)th trade, and dei 1 is the corresponding
history of durations. g(di jdei 1 ; rei 1 ; 1i ) is the distribution of duration for the ith trade
conditional on information about past returns and durations, while q(ri jdi ; dei 1 ; rei 1 ; 2i ) is
the distribution of return of the ith trade conditional on past information as well as its
contemporaneous duration di . We assume that parameters 1i and 2i are variation free so
that they can be estimated separately. After estimating the model, the forecasting of returns’
volatility of the next trade can be carried out in two steps: …rst is to forecast the duration
of the next trade and then forecast return’s volatility conditional its duration.

2.1 ACD model for duration

We use ACD model proposed by Engle and Russell (1998) for gb(di jdei 1 ; rei 1 ; 1i ).

dt;i = E(dt;i jFt;i 1 ) i

where i ~iid with density f ( ) and E( ) = 1. Here, all the past information is captured
in the conditional mean function and i can be viewed as new information coming during
tt;i 1 and tt;i .
The expected duration has both deterministic and stochastic components. One important
deterministic component is time of day e¤ect, which can be formulated as a multiplicative
function to the stochastic part. Therefore, the expected duration is written as

7
 E(dt;i jFt;i 1 ) = (tt;i 1 ; ) b b
t;i (dt;i 1 ; :::d1;1 ; ) (2)

where dbt;i = dt;i = (tt;i 1 ; ) is ’diurnally adjusted’durations.

The stochastic component of conditional distribution b b
t;i (dt;i 1 ; :::d1;1 ; adapts a GARCH
process which could potentially depend on past returns:

X X X
b b
t;i (dt;i 1 ; :::d1;1 ; )= d + pj i j + qj dbt;i j + j jri j j (3)
j=1 j=1 j=1

where ri j are the past returns.

We use Generalized Gamma as the distribution of innovation term i, i.e.

am am 1 a
a i expf ( i) g
f ( i) = (4)
(m)

The generalized Gamma reduces to the Weibull when m=1, to the two –parameter
Gamma distribution when , and to the Exponential model when m = 1, to the two-parameter
Gamma distribution when = 1, and to the Exponential model when = m = 1.

2.2 Returns’distribution conditional on current duration and past

information

2.2.1 Structured Model

In the previous section, we have analyzed the trading duration conditional on past informa-
tion; in this section, we model the return and it’s volatility given current duration and past
information ) q(ri jdi ; dei 1 ; rei 1 ; 2i ). In our paper, we model return as a continuous variable,
but in reality, prices change by tick size instead of continuously, so return should be a discrete
variable. The discreteness of return is most signi…cant before 1997 when tick size is 1/8 of a
dollar and most of the price changes are just one or two tick sizes. However, since January

8
2001, the tick size has been reduced to a penny, so modeling return as a continuous variable
should be less of a problem.
There are two issues mainly considered in this paper: …rst, how to extract information
about unobserved underlying e¢ cient price process from the observed trading prices. Second,
how duration should enter the conditional density.
Let mt;i be the unobserved e¢ cient price for the ith transaction on date t. Since it is the
market beliefs conditional on all public information, e¢ cient market hypothesis implies that
it follows a random walk process. Then rt;i = mt;i mt;i 1 is the innovation of the e¢ cient
price between (i-1)th and ith trade on date t.

mt;i = mt;i 1 + !(t;i) ! i (5)

where where ! i ~IIDnormal(0; 1): !(t;i) ! ii re‡ects new information incorporated in the e¢ -
cient price from the ith trade on date t. It has time varying volatility !(t;i) , which we model
as following:

s
dt;i
!(i;t) = ht st;i gt;i (6)
T

ht is the forecasted daily volatility from information up to date t-1, it captures a relatively
long term e¤ect (past several days’information). st;i is the time of day e¤ect of ith trade
at date t. gt;i is the forecasted volatility for the ith tick return conditional on information
up to (i 1)th trade of date t. which captures the short term e¤ect (past several trades)
on volatility. dt;i is the duration from (i 1) th to ith transaction, and is the parameter
governing the speed of information arrivals. is bigger than/equal to/smaller than 1 if
information is incorporated faster/equal/slower than linearly in time. We model ht and gt;i
as GARCH process and time of day e¤ect as exponential linear spline, so

ht = c1 + c2 ht 1 + c3 rt2 1 (7)

9
 rt;i2
1
gt;i = r + r gt;i 1+ r dt;i 1
(8)
ht st;i 1 ( T )

X6
o +
st;i = cso exp( csj ( t;i j) ) (9)
j=1

where rt 1 denotes the daily return for date t 1.

To make the model identi…able, we impose several parameter restrictions:

c1
E(ht ) = = V ar(rt2 ):
1 c2 c3

dt;i
E(st;i )=1
T

We model the observed price pt;i as a summation of e¢ cient price mt;i and market mi-
crostructure noise ut;i ,
pt;i = mt;i + ut;i (10)

where ut;i is a zero-mean covariance stationary process.

Existing market microstructure theories have suggested multiple sources of ut;i : one of
the sources is asymmetric information between informed investors and the rest of the market,
which we call "informational component". Since it re‡ects the amount of news in the market,
it should be correlated with the e¢ cient price innovation. In contrast, the "noninformational
component" is mostly likely due to transaction cost or inventory control. Although it’s
possible that the components themselves are autocorrelated, the autocorrelation structure
are not obvious. Therefore, we model the two components using two ARMA processes
respectively.

10
 ( 0 + 1 L + 2 L2 + + q1
q1 L ) (1 + B1 L + B2 L2 + + Bq2 Lq2 )
ut;i = 2 p1 !(t;i) ! i + i (11)
(1 1L 2L p1 L ) (1 A1 L A2 L2 Ap2 Lp2 )

where i ~IIDnormal(0; ), and E(! i i ) = 0

The observed return rt;i is then

rt;i = pt;i pt;i 1 = !(i;t) ! i + (1 L)ut;i (12)

" #
( e0 + e1 L + e2 L2 + + er1 1 Lr1 1 )
= 2 p1 !(t;i) ! i
(1 1L 2L p1 L )

e1 L + B
(1 + B e2 L2 + eq2+1 Lq2+1 )
+B
+ i (13)
(1 A1 L A2 L2 Ap2 Lp2 )

where r1 = max (p1 + 1; q1 + 2).

Note from equation 8 that the unobserved e¢ cient return rt;i determines how gt;i evolves,
therefore, rt;i is a nonlinear function of the unknown ! i . The nonlinear system is often
…rst linearized by …rst order approximation and then use Kalman …lter to estimate the
linearized one. However, in our model, ! i enters recursively into the equation of rt;i , so rt;i
potentially could depends on in…nite orders of lagged ! i s, which means taking the …rst order
approximation is not straight forward. Therefore, we use another way of approximation by
expressing gt;i as function of observed return rt;i :
Since ! i and i are uncorrelated, the variance of rt;i is the sum of the variance of the two
innovation terms.

" #
2 ( e0 + e1 L + e2 L2 + + er1 1 Lr1 1 )
E rt;i = var( 2 p1 !(t;i) ! i ) + constant
(1 1L 2L p1 L )

Let
( e0 + e1 L + e2 L2 + + er1 1 xr1 1 )
f (x) = 2 p1
(1 1L 2L p1 x )

11
 Taking Taylor Expansion of f (x) around x = 0, we have

X
1
f (n) (0)
f (x) = xn
n=0
n!

It can be shown using Autocovariance-Generating Function that

" 2
#
X1
f (n) (0)
2 2
E rt;i = E !(t;i) + constant
n=0
n!

2
rt;i constant
Therefore substitute rt;i2 1 for P h (n) i2 into equation 8, and rearrange, we have
1 f (0)
n=0 n!
2
rt;i
gt;i = e + gt;i 1 + h i P h i2
d 1 f (n) (0)
ht st;i 1 ( t;iT 1
) n=0 n!

constant
where e = h i P h (n) i2 ; note e may become negative if
dt;i 1 1 f (0)
E ht st;i 1( T ) n=0 n!

constant h
P1 f (n) (0) i2
< h i P h i2 . n=0 n!
is the coe¢ cient to adjust in the
dt;i 1 1 f (n) (0)
E ht st;i 1( T ) n=0 n!

denominator of ARCH term when rt;i is used.

For example, suppose ut;i is the sum of two independent ARMA(1,1) processes,

( 0 + 1 L) (1 + B1 L)
ut;i = !(t;i) ! i + i
(1 1 L) (1 A1 L)

then

" #
( e0 + e1 L + e2 L2 ) e1 L + B
(1 + B e2 L2 )
rt;i = !(t;i) ! i + i
(1 1 L) (1 A1 L)

" #
( e0 + e1 L + e2 x2 ) X1
f (n) (0) n e X1
f (x) = = x = 0 +x e1 + e0 1 + e2 + e1
1 + e0 2
1
n n+2
1x
(1 1 x) n=0
n! n=0

12
 Then the adjusting coe¢ cient for ARCH in gt;i is

" # e2 + e1
2
X1
f (n) (0)
2
2 2 1 + e0 2
1
= e0 + e1 + e0 1 + 2
n=0
n! 1 1

In summary, the structure model for transaction prices, the e¢ cient prices and mi-
crostructure noises are as follows:

pt;i = mt;i + ut;i (14)

mt;i = mt;i 1 + !(t;i) ! i (15)

( 0 + 1 L + 2 L2 + + q1
q1 L ) (1 + B1 L + B2 L2 + + Bq2 Lq2 )
ut;i = 2 p1 !(t;i) ! i + i (16)
(1 1L 2L p1 L ) (1 A1 L A2 L2 Ap2 Lp2 )

rt;i = pt;i pt;i 1 = !(i;t) ! i + (1 L)ut;i (17)

2.2.2 Special cases of the structured model

The structured model 14 - 17 is a general form that encompasses a wide range of speci…c
microstructure models.

Roll Model The evolution of the e¢ cient price is given by mt = mt 1 + ! t :The observed
price process pt is the e¢ cient price adjusted by order processing cost.

pt = mt + cqt

where qt is the trading direction. qt = 1 if a trade is initiated by a buy order and qt = 1 if

a trade comes from a sell order. Then the observed return is

13
 rt = p t = ! t + c qt

It’s easy to see that Roll model matches with our model when ut;i = i.

Stale Prices The beliefs of market participants at time t are given by mt = mt 1 +wt . But
due to slow operational systems, trades actually occur relative to a stale price: pt = mt 1 +cq.
wt and qt are uncorrelated at all leads and lags. Then

rt = wt + (1 L)( wt + cqt )

This is a special case of our model where 1 = 2 = p1 = 0; 0 = 1; 1 = 2 =

::: q1 = 0; A1 = A2 = Ap2 = B1 = = Bq2 = 0 and i = cqt

Lagged adjustment The beliefs of market participants at time t are given by mt =

mt 1 + wt : But trade prices adjust to beliefs gradually: pt = pt 1 + (mt pt 1 ):

pt = mt + (1 ) pt 1

rt = pt = wt
(1 1 )L
( 1) + (1 )L
= wt + wt
1 (1 )L

Matching to our model, 1 = (1 ), 2 = p1 = 0; e0 = 1; e1 = (1 ),

e2 = :::eq = 0; and =0
1

Inventory Control Market makers’objective is to maintain a q inventory through the

adjustment of bid and ask quote, therefore the trading directions of market orders will follow

14
a mean-reverting process. Let qt be the trading direction, qt q = (qt 1 q ) + "t . The
observed price is again pt = mt + cqt

rt = pt = wt + (1 L)cqt
c"t
= wt + (1 L)
(1 + L)

i
This is a special case of our model when t = c"t , and ut;i =
(1 + L)

Asymmetric information The evolution of the e¢ cient price is given by mt = mt 1 +wt ,

The increments to the e¢ cient prices are driven by trades and public information. wt =
qt + ut . The actual rice is pt = mt + cqt :So the observed return is

rt = pt = qt + ut + (1 L)cqt

= wt + (1 L)(awt + et )c=

var(qt ) (1 a )wt ut
where a = 2
var(qt )+var(ut )
, et = : It is easy to show that wt and et are uncorrelated.
Our model is the same as this speci…cation when !(i;t) ! i = wt , and 1 = 2 = =

p1 = 0; 0 = ac= ; 1 = ::: q = 0; A1 = A2 = Ap2 = 0 B1 = B2 = = Bq2 = 0and

i = cet = :

2.2.3 Kalman Filter speci…cation

The structured model (5)-(12) can be estimated through Kalman Filtering. Appendix A
shows the equivalency of the structured model and the following state space model.

15
 Let state equation be:

2 3 2 3
1 2 r1 !(t;i+1) ! i+1
6 7 6 7
6 7 6 7
6 1 0 0 0 7 6 0 7
6 7 6 7
6 .. .. 7 6 .. 7
2 3 6
6 . . 0 (r1 r2 ) 7
72
6 . 7
6 7 3 6
6
7
7
6 i+1 7 6 7 6 7
6 7 6 0 1 0 76 i 7 6 0 7
7=6 74 5+6 7
(r1 1)
6
4 5 6
6 A1 A2
7
Ar 2 7
6
6
7
7
i+1 6 7 i 6 i+1 7
(r2 1) 6 7 6 7
6 0 1 0 0 7 6 0 7
6 7 6 7
6 7 6 7
6 .. ... 7 6 .. 7
6 (r2 r1 ) . 0 7 6 . 7
4 5 4 5
0 1 0 0
(18)
Observation equation:

2 3

e0 e1 er e1 er2 6 i 7
rt;i = 1 1 1 B B 1 4 5 (19)
i

where r1 = max(p1 + 1; q1 + 2); r1 = 0 for r1 > p1 ; er1 = 0 for r1 > (q1 + 1) and r1 > p1
er2 = 0 for r2 > (q2 + 1)
r2 = max(p2 ; q2 + 2); Ar2 = 0 for r2 > p2 ; B

i is an r1 1 vector, and i is an r2 1 vector.

2 3
1 2 r1
6 7
6 7
6 1 0 0 0 7
6 7
6 .. .. 7
6 . . 0 (r1 r2 ) 7
6 7
6 7
6 7
6 0 1 0 7
Let F =6
6
7
7 H0t;i =
(r1 +r2 ) (r1 +r2 ) 6 A1 A2 Ar 2 7 (r1 +r2 ) (r1 +r2 )
6 7
6 7
6 0 1 0 0 7
6 7
6 7
6 .. .. 7
6 (r2 r1 ) . . 0 7
4 5
0 1 0

e0 e1 er 1
e1
1 B er2
B 1
1

16
 2 3
!(t;i+1) ! i+1
6 7
6 7
6 0 7
6 7
6 .. 7
6 . 7
6 7 2 3
6 7
6 7
6 0 7 6 i+1 7
vi+1 = 6
6
7 xi+1 = 6
7 4
7
5
(r+1) 1 6 7
6 i+1 7 i+1
6 7
6 0 7
6 7
6 7
6 .. 7
6 . 7
4 5
0

xi+1 = Fxi + vi+1

rt;i = H0 xi

8 2 3
>
> 2
>
> !(i;t) 0 0
>
> 6 7
>
> 6 7
>
> 6 0 0 0 7
>
> 6 7
>
> 6 .. .. 7
>
> 6 . . 0 7
>
> 6 7
>
> 6 7
>
> 6 7
>
> 6 0 0 0 7
< 6 7 = Q for i = j
6 7
Et;i 1 (vi vj0 ) = 6 0 0 0 0 0 7
>
> 6 7
(r1 +r2 ) (r1 +r2 ) >
> 6 7
>
> 6 0 0 0 7
>
> 6 7
>
> 6 7
>
> 6 .. ... 7
>
> 6 . 0 7
>
> 4 5
>
>
>
> 0 0 0
>
>
>
>
: 0 for i 6= j

Using the Kalman Filter to evaluate the likelihood function, and assuming normality of
rt;i 1 ; dt;i ; det;i 1 g:
x1 and v1 , we obtain the distribution of rt;i conditional on fe

ri 1 ; dt;i ; d~i 1 )~N

rt;i j(~ H0 x
biji 1 ; H0 Piji 1 H (20)

17
 " 2
#
1 rt;i H0 x
^iji 1
frt;i j(~ri ~
1 ;dt;i ;di 1 )
=q exp (21)
(2 ) H0 Piji 1 H 2 H0 Piji 1 H

1
^i+1ji = F^
x xiji 1 + FPiji 1 H H0 Piji 1 H rt;i H0 x
^iji 1 (22)
h i
0 1 0
Pi+1ji = F Piji 1 Piji 1 H H Piji 1 H H P0iji 1 F0 + Q (23)

3 Application: forecasting volatility using transaction

data

3.1 Data description

This section applies the model to transaction data from TAQ database. We randomly pick
10 stocks traded on NYSE with di¤erent trading frequencies. The Sample period is from
Jan, 2003 to May, 2003. All trades before 9:30 AM or after 4:00pm are discarded. To take
out the overnight duration e¤ect, the …rst trade after 9:30 for each day is excluded. For
transactions happen at the same time, we take the transaction size weighted price as the
price for that time and remove all zero durations. It’s very possible to have data error in
the high frequency data, but it is also very hard to tell. Some extremely large magnitude
of returns for a single trade is very unlikely, therefore we …lter out observations where the
di¤erence between price and midquote is larger than 1/3 of midquote. Finally, we only
include observations whose correction indicator variable has value of 0 or 1. Returns are
calculated by the price change divided by lagged price. All the returns are in unit of basis
point. Daily returns for estimating daily garch ht is the holding period return taken from
CRSP. Table 1 summarizes the number of observations for each stock in our sample.

18
3.2 Parameter estimation

The measures that we are mostly interested in in this paper are the dependence of tick
volatility on duration- , and how much microstructure noises contaminate the e¢ cient price.
Table 2 summarize these estimates for each datasets. They shed light on existing microstruc-
ture theory and time series modeling for high frequency data, which we will discuss in more
detail in the next section.
Although the other parameters are equally indispensable for the model, they either have
been studied in great detail in other papers, such as parameters in ACD model, or they are
mainly statistical instruments for better …tting the data, among them are time of day e¤ect
and daily volatility ht . Therefore, we will only report all the estimation results for one of
the companies–ASL, and use the stock as an example to illustrate how to apply the model
to forecast future volatility.
Parameter estimates for ACD model are presented in table 4, while parameter estimates
for Kalman Filter model are in table 5. First, we …nd that ACD(4,2) …ts the duration
data satisfactorily: the residual from the model has a mean insigni…cantly di¤erent from 1.
(P-value =0.9888), and the Ljung-Box statistics show that the autocorrelation and partial
autocorrelation until the 15th lag are all insigni…cant. Figure 3 graphically tests the goodness
of …t of generalized gamma model for duration. The probability plot of standardized duration
distributes closely along the line, suggesting generalized gamma is a reasonable distribution
assumption for duration.
For the Kalman Filter model of return, we use AIC and Likelihood ratio test to determine
how many ARMA terms should be included for the two parts of microstructure noise. The
model chosen is an AR(1) process for the informational component and an ARMA(2,1)
process for the noninformational components, i.e. ut;i = (1 0 L) !(t;i) ! i + (1 (1+B 1 L)
A1 L A2 L2 ) i
,
h e e i e1 L+B
e2 L2 )
1

L)
and rt;i = ((10 + 1L) (1+B
!(t;i) ! i + (1 A1 L A2 L2 ) i . Interestingly, the coe¢ cient of duration is not
1

signi…cantly di¤erent from 0, which suggests that volatility of return per trade is constant
over time and volatility per second is decreasing in duration. This is consistent with Easley

19
and O’Hara(1987)’s prediction that long durations indicate no news and lower volatility.
More microstructure implications from the duration coe¢ cient will be discussed in the next
section. Another interesting observation is that both informational and noninformational
components have signi…cant loadings on microstructure noise, suggesting multiple sources
for bid-ask spread. On the one hand, microstructure noise is correlated with e¢ cient price
innovation for the reason of asymmetric information or lagged price adjustment; on the other
hand, transaction cost and inventory control by dealer bring …xed component to the bid-ask
spread.
Finally, seasonality pattern of duration and volatility are plotted in Figure 1 and 2.
Two spline functions are used to adjust for the daily seasonality of duration and volatility
respectively. We apply linear spline function to adjust for time of day e¤ect for duration,
and exponential linear spline for tick by tick volatility, with nodes set on each hour. Figure
1 is the nonparametric estimate daily pattern for duration, which shows a clear inverted "U"
shape similar to Engle and Russell (1998), suggesting that the trading frequency is higher at
the beginning and toward the end of each day. Figure 2 shows the daily pattern of volatility
of return. In contrast, tick by tick volatility shows a "U" shape, suggesting the stock tends
to be more volatile at beginning and toward the end of the day.

3.3 Forecasting volatility for ASL

Standard time series models usually require converting data into …xed time, but this may
incur a loss of information if the time interval is too broad. Tick by tick models could
potentially use all information, but it can only predict volatility over the next trade with-
out further information on duration. Full speci…cation of the joint distribution of return
and duration allows us to forecast volatility within arbitrary time interval, and utilize the
information of all trades at the same time.
The forecasting procedure is carried through simulation: …rst we estimate the model
using data over some period, and then simulate 500 paths of returns and durations for the

20
next day using data of today as starting values. Note tick by tick durations and returns
are simulated in an iterative fashion: for each iteration, a duration is …rst simulated based
on past information, and then conditional on the simulated duration, tick return is then
simulated. As a comparison, both conditional volatility for the e¢ cient price innovation and
realized volatility of observed returns are simulated. Taking average of the simulated realized
volatility across 500 paths, we obtain an estimate of the forecasted volatility. To evaluate
the distribution of the estimators, we repeat the above simulation procedure 500 times and
obtain an empirical distribution of the estimator.
.Table 6 compares various measures from simulated data with the ones from the sample.
The simulated data matches with the sample fairly well: all measures from the real data
resides in the con…dence interval of estimates from the model. However, it is more interesting
to discuss properties of data which are not directly observable. First, with assumption
about some starting values, we can back out the e¢ cient price mt;i , and the corresponding
microstructure noise ut;i . Figure 4 and 5 depict how pt;i , mt;i and ut;i evolves over time.
The observed transaction price and the e¢ cient price are cointegrated with a stationary
di¤erence ut;i . It’s hard to see from the graph, however, which of the price process are more
volatile, so …gure 6 plots the daily realized volatility and daily volatility for e¢ cient price
change from the simulated data. It can be seen clearly that realized volatility calculated
from high frequency data are upward biased estimate of volatility of e¢ cient price change.
On average, the ratio of the two are 0.7323, suggesting that realized volatility are biased by
36.56%. Within the microstructure noise, 85.70% of the variance of ut;i are due to variation
in the informational component, while the remaining 14.30% comes from noninformational
part.

21
4 What can we learn about the microstructure theory?

4.1 Information from Duration

Our model examines the dependence of tick by tick volatility of e¢ cient price innovation
on duration between trades, which is summarized by parameter . Table 2 summarizes the
estimated for each dataset. with a value of 1 suggests that news is incorporated into
price linearly in time, which translates to volatility over a …xed interval is independent of
number of trades. This is consistent with the standard assumption that price follows an
unobserved continuous process with a Brownian motion innovation, and the observed price
is just a random sample of this process at discrete times. If this is the case, transforming
the irregularly spaced data into …xed intervals will render stationary time series, where the
variance and autocovariance only depend on the number of lags between two observation,
not on the location of them. Appealing as it looks, however, our estimation results do not
support the above assumption. All the data give estimates of signi…cantly less than 1. 6 out
of 10 estimates are insigni…cantly di¤erent from 0. This suggests that tick-time stationarity
is a better description for high frequency …nancial data than stationarity in wall-clock time.
In other words, tick by tick volatility might have a shorter memory than volatility over …xed
time interval, therefore it is more appropriate to build a parsimonious model on tick by tick
data. In light of forecasting volatility over a certain period, one can use tick by tick data to
forecast number of trades in that period, given tick by tick volatility relatively stable, the
higher is the number of trades, the higher the total volatility will be. Note this will give
an additional reason for volatility to be time varying, which traditional equally spaced time
series models tend to ignore. Therefore, taking into account of trading frequency will render
a more e¢ cient forecast of volatility, especially when forecasting horizon is not tremendously
larger than the average duration between trades.
with a value bigger/smaller than or equal to 0 can also shed lights on microstructure
theory about the trading behavior in the market. Trading intensity and trading volume are

22
two sides of the same coin. Suppose informed traders received private information about
a stock, they can either trade a few large blocks of securities or divide the large blocks
into smaller sizes and quickly trade out their position. Easley and O’Hara (1987) models
this trade size decision by informed traders. In their model, either separate or pooling
equilibrium can be derived depending on market conditions. We argue that the trading
behavior in pooling equilibrium provides one possible explaination of why is zero in most
of our datasets. In pooling equilibrium, with positive probability, the informed traders will
divide large blocks into smaller size to hide their position from other traders, so that they will
reduce price impacts when trading with dealers. In such a case, the amount of information
incorporated into prices each trade is likely to stay stable given the constant trading volume.
Therefore, the total amount of news that informed investor have will determine how many
smaller trades they need to submit, in other words, trading intensity will be higher/lower
when the total information is higher/lower. Pooling equilibrium tends to be reached when
few uninformed traders are willing to trade large quantities or when a market has a high
probability of informed based trading. This tends to be the case for smaller …rms whose
operations are more opaque and receives less attention from equity analysts, and these …rms
are also traded less frequently. Table 2 shows that all …rms with number of trades less than
200,000 have equal to either zero or a small negative number, while larger …rms such as
IBM and Boeing Airline have signi…cantly bigger than zero.
less than zero implies there might be uninformed investors trying to follow the footstep
of informed traders, so that whenever information comes both the informed and uninformed
investors increase their trading frequency. In such a market, information will be incorporated
into price faster than without uninformed traders, therefore the duration between trades and
volatility of tick returns will be negatively correlated. This is more likely to happen when
the securities are believed to have a lot of private information, where uninformed traders
are more likely to bene…t from following the informed traders. Note the overall trading
frequencies will be low for such …rms since many uninformed traders will simply stay away

23
from them. This is exactly the situation for our datasets. The only two companies that have
signi…cantly negative are also the …rms with the lowest number of trades. In contrast,
more frequently traded securities render higher estimates of . In our sample, the most
heavily traded stock–IBM also has the highest estimate of . . with a value larger than 0
suggests that the trading intensity increases less than linearly with the amount of news, so
that per trade volatility will be higher for longer durations. This tends to happen to large
…rms where uninformed investors dominant the informed. Investors often trade large …rms’
stocks for reasons other than the …rms own news, for example, S & P component stocks’
prices tend to move with S & P index closely, therefore investors trading intensity is less
sensitive to the …rm speci…c news. Note the above discussions are based on casual conjecture,
more elaborate theoretical models capturing both the random occurrence of news events and
investors’decision on trading intensity need to be built in order to make any …nal conclusion.
But our empirical …nding might provide some insights on how to build such a model.
Finally, the …nding that tick by tick volatility are homogenous of degree 0 to duration
is coherent with several other empirical …ndings. First, using equally spaced data, Jones,
Kaul and Lipson (1994) …nds that "the positive volatility-volume relation actually re‡ects
the positive relation between volatility and the number of transactions. Thus, it is the
occurrence of transactions, per se, and not their size, that generates volatility". This is
consistent with our conjecture that informed investors tend to break down large block of
trades into a sequence of smaller ones, then information is absorbed into prices little by
little at a roughly constant magnitude per trade. Russell and Engle (1998) …nds that low
intertrade duration is associated with high volatility per second, and our model …nds that
the two quantities tend to be inversely related.

4.2 Microstructure noise in high frequency data

One interesting question is how much the observed prices are contaminated by the microstruc-
ture noise if one want to use tick by tick data to estimate volatility. Table 3 summarizes

24
the ratio of expected volatility for e¢ cient price innovation and the volatility of observed
returns. We …nd a lot of variation in the ratio, ranging from 0.0106 to 0.9830. Overall
2
our estimates of volatility of e¢ cient price innovation !(t;i) are smaller than the realized
volatility, suggesting using realized volatility for high frequency data might overestimate the
true underlying price variation because microstructure noises are not taken into account.
The degree of such contamination can be as high as 99% as in some of the stocks, so for
these stocks, it is a must that microstructure noises are …ltered out …rst if one want to use
high frequency data. Table 3 also shows the best model of microstructure noise ut;i for each
dataset, 9 out 10 stocks require both the informational components and noninformational to
explain bid-ask spread.

5 Concluding Remarks

The paper proposes an econometric model for the joint distribution of tick by tick return and
duration, with microstructure noise explicitly …ltered out. We can easily forecast volatility
of returns over any arbitrary time interval through simulation using all the observation
available. We take into account of the dependency of return on duration when forming
the forecast, therefore avoid the unnecessary e¢ ciency loss from transforming the data into
equally spaced ones. Interestingly, we …nd that for most of the data, tick by tick volatility
is homogeneous degree of zero to duration, suggesting stationarity in transaction time. This
has implications for both empirical modeling of high frequency data and theory on market
microstructure.
The speci…cation for microstructure noise in our model is general enough to encompass
most of the models from microstructure theory, and the estimation results suggest that
both asymmetric information and …xed transaction cost are important resources for bid-ask
spread. Moreover, transaction prices can be contaminated by the noise to a great extend,
and the degree of such contamination varies from stock to stock.

25
 One point we want to make clear is that modeling return conditional on duration does
not mean duration is an exogenous process set before price. In reality, trading frequency and
volatility should be contemporaneously determined, our modeling of return as conditional
distribution is only a strategy to obtain joint distributions. Equally interesting, one could
also go from price process …rst, and model duration conditional on its contemporaneous
return. And …nally, a bivariate state space model for both return and duration could make
the source of dependency between the two variables more speci…c. It would be interesting to
compare the results from the three models, and see to what extend can duration and price
be isolated.

26
 References

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 Glosten, Lawrence R., 1994, Is the electronic open limit order book inevitable?, Journal
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28
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29
 Appendix

Appendix A: Transform the Structured Model for Return to State Space Model
Substitute equation 11 for ut;i in equation 12 and rearrange

(e0 + e1 L + e2 L2 + + er1 1 Lr1 1 ) e1 L + B

(1 + B e2 L2 + er2 1 Lr2 1 )
+B
rt;i = 2 r1 !(t;i) ! i + i
(1 1L 2L r1 L ) (1 A1 L A2 L2 Ar 2 L r 2 )
(24)
where r1 = max(p1 + 1; q1 + 2); r1 = 0 for r1 > p1 ; er1 = 0 for r1 > (q1 + 1) and r1 > p1
er2 = 0 for r2 > (q2 + 1)
r2 = max(p2 ; q2 + 2); Ar2 = 0 for r2 > p2 ; B
prove that 18-19 can be written in the form of 24 :
Let j;i be the jth entry of the vector i, then from 18 we have

1;i+1 = 1 1;i + 2 2;i + + r1 r1 ;i + !(t;i+1) ! i+1 (25)

2;i+1 = 1;i =L 1;i+1

3;i+1 = 2;i = L2 1;i+1

..
.

r1 ;i+1 = Lr1 1
1;i+1

Plug 2;i+1 ; 3;i+1 ; ; r1 ;i+1 into 25 and rearrange the equation

!(t;i+1) ! i+1
1;i+1 = 2 r1
(26)
(1 1L 2L r1 L )

Similarly, let j;i be the jth entry of the vector i, then from 18 we have

30
 i
1;i+1 = 2
(27)
(1 A1 L A2 L Ar 2 L r 2 )

Expande equation 19,

rt;i = e0 1;i + e1 2;i + + er 1 r1 1;i + 1;i

e1
+B 2;i + er2
+B 1 r2 1;i (28)

= (e0 + e1 L + e2 L2 + + er1 1 Lr1 1 ) 1;i

e1 L + B
+ (1 + B e2 L2 + er2 1 Lr2 1 )
+B 1;i

Finally, equation 24 can be obtained by plugging 26 and 27 into 28,

31
 Table 1: Summary Statistics
Ticker Company Name Number of Mean # of
Obs. trades/day
ASL ASHANTI GOLDFLDS 23832 233.65
BA THE BOEING CORP. 279900 2717.48
CDI CDI CORP. 13425 130.34
CTX CENTER CORP. 196920 1911.85
FUN CEDAR FAIR DEP R L.P. 10434 101.30
IBM INTL BUSINESS MACH 419994 4077.60
LUK LEUCADIA NATIONAL CORP. 27584 267.81
OMM OMI CORP 14899 144.65
RGR STURM RUGER & CO INC. 12318 119.59
WSO WATSCO INC 7918 76.87
The Sample period is from Jan, 2003 to May, 2003. All trades before 9:30 AM or after 4:00pm
are discarded. To take out the overnight duration e¤ect, the …rst trade after 9:30 for each day is
excluded

Table 2: Parameter Estimates

Stock # of trades r r r
0:0137 1:1367e 04 0:8977 0:0768 0:2966
ASL 23832
[0 :0262 ] [9 :5620e 06 ] [0 :0253 ] [0 :0075 ] [0 :0947 ]
0:0718 1:088e 06 0:9916 0:0093 2:6005
BA 20000
[0 :0331 ] [5 :13e 07 ] [0 :0019 ] [0 :0018 ] [0 :3637 ]
0:0197 1:5365e 04 0:9111 0:0490 7:9219
CDI 13425
[0 :0182 ] [1 :0926e 04 ] [0 :0244 ] [0 :0128 ] [7 :3904 ]
0:0474 6:055e 06 0:9623 0:0180 3:3802
CTX 20000
[0 :0538 ] [4 :606e 06 ] [0 :0351 ] [0 :0136 ] [2 :2751 ]
0:0609 5:56e 07 0:8324 0:0701 77:5028
FUN 10434
[0 :0317 ] [1 :970e 06 ] [0 :0364 ] [0 :0136 ] [4 :8181 ]
0:3136 9:3000e 08 0:6197 0:1239 0:9802
IBM 20000
[0 :0781 ] [8 :60e 07 ] [0 :0262 ] [0 :0146 ] [0 :0341 ]
0:0281 9:000e 06 0:9362 0:0414 0:3479
LUK 27584
[0 :0240 ] [4 :025e 06 ] [0 :0081 ] [0 :0060 ] [0 :3251 ]
0:0317 1:0996e 04 0:9226 0:0727 0:0295
OMM 14899
[0 :0444 ] [5 :0165e 05 ] [0 :0205 ] [0 :0300 ] [0 :0346 ]
0:0352 8:2740e 05 0:8764 0:0598 0:2885
RGR 12318
[0 :0219 ] [7 :316e 06 ] [0 :0150 ] [0 :0080 ] [0 :0165 ]
0:0916 1:3200e 06 0:8902 0:0648 10:7609
WSO 7918
[0 :0252 ] [5 :1400e 07 ] [0 :0151 ] [0 :0099 ] [1 :2332 ]
Estimates for selected paramters from the Kalman Filter model. is the volatility dependency on duration,
r , r and r are parameters for tick by tick garch gt;i . is the variance for i . Robust standard errors are
included in the squared brakets. Only the …rst 20000 observations are used in the estimation for companies
BA, CTX and IBM because of the large sample size of these data.

32
 Table 3: microstructure noise
E( 2!(t;i) )
Stock Model Picked for ut;i E 2!(t;i) Var(rt;i ) Var(r )
Upward Bias
t;i
AR! (1)
ASL 358.0137 459.3679 0.7794 0.2830
+ARM A (2; 1)
ARM A! (1; 1)
BA 17.5365 19.6759 0.8913 0.1220
+ARM A (2; 1)
ARM A! (1; 1)
CDI 157.3984 169.4789 0.9287 0.0768
+ARM A (1; 1)
ARM A! (1; 1)
CTX 0.1281 13.1829 0.0106 93.3396
+ARM A (2; 1)
M A! (1)
FUN 11.0126 158.9854 0.0693 13.4300
+ARM A (2; 1)
ARM A! (1; 1)
IBM 1.3143 7.7085 0.1705 4.8651
+ARM A (2; 1)
LUK ARM A (2; 1) 31.7379 56.8966 0.5578 0.7928
M A! (1)
OMM 566.0966 575.8980 0.9830 0.0173
+ARM A (3; 2)
M A! (1)
RGR 397.5894 587.5488 0.6767 0.4778
+ARM A (2; 1)
ARM A! (1; 1)
WSO 99.154 254.6219 0.3890 1.5707
+ARM A (1; 1)
Median 0.61725 0.6356
AIC and Likelihood ratio test are used to choose the best model. AR! (1) stands for AR(1)
process for the information component in ut;i , ARMA (1; 1) means ARMA(1,1) model is picked
for noninformational component. E( 2!(t;i) ) is the mean of conditional volatility for e¢ cient price change.
var(rt;i )
V ar(rt;i ) is the unconditional variance for tick returns. Upward bias is calculated as E( 2!(t;i) )
1.

33
 Table 4: ACD(1,1) with Generalized Gamma error for ASL
Parameter Estimate Std.Error Prob.
d 0.0308 0.0152 0.0431
p1 1.8489 0.0224 0.0000
p2 -0.8502 0.0219 0.0000
q1 0.0781 0.0049 0.0000
q3 -0.1544 0.0150 0.0000
q4 0.0774 0.0113 0.0000
1 0.0006 0.0005 0.1621
a 7.8855 1.1657 0.0000
m 0.2180 0.0164 0.0000
c 0.738519 0.069521 0.0000
c0 4.12E-05 5.25E-05 0.4323
c1 7.64E-05 6.66E-05 0.2514
c2 -0.000108 3.69E-05 0.0035
c3 2.15E-05 3.77E-05 0.5689
c4 -5.61E-05 3.86E-05 0.1453
c5 -0.000118 3.79E-05 0.0018
c6 -0.000132 5.76E-05 0.0216
Statistics for Residual i
Mean 1.0002
Std. Dev 1.7319
Ljung-Box 16.2839
Prob. 0.3634
am m 1 a
a i expf ( i ) g
i ~iid; f ( i ) =
(m)
b b
t;i (dt;i 1 ; :::d1;1 ; ) = d + p1 t;i 1 + p2 t;i 2 + q1 dbt;i 1 + q3 dbt;i 3 + q4 dbt;i 4 + 1 jri 1 j
(tt;i 1 ; ) = c + c0 tt;i 1 + 6j=1 cj max(tt;i 1 ; nodj ; 0)

34
 Table 5: Kalman Filter Estimate for return condition on duration
Parameter Estimate Std. Error Prob.
r 0.0120 0.0172 0.4854
r 1.1367e-04 9.5620e-06 0.0000
r 0.8977 0.0253 0.0000
r 0.0768 0.0075 0.0000
cs1 -0.0069 0.0166 0.6777
cs2 0.0078 0.0364 0.8303
cs3 -0.0023 0.0060 0.7015
cs4 1.2881e-05 0.0785 0.9999
cs5 -0.0140 0.0472 0.7668
cs6 0.0412 0.0053 0.0000
1 0.3438 0.0053 0.0000
e0 1.1542 0.1987 0.0000
e1 -0.5484 0.3615 0.1293
A1 1.8420 0.3927 0.0000
A2 -0.8552 0.3359 0.0109
Be1 -1.8224 1.1667 0.1183
Be2 1.0365 0.5448 0.0571
0.2966 0.0947 0.0017
L -1.0426e+05
AIC 2.0860e+05 s
dt;i
!(i;t) = ht st;i gt;i
T
rt;i2
1
gt;i = r + r gt;i 1 + r dt;i 1
ht st;i 1 ( T )
P6 o +
st;i = cso exp( j=1 csj ( t;i j) )
( e0 + e1 L+ e2 L2 + +er1 1 L 1 1 )
r
(1+Be1 L+B e2 L2 + +B
eq
2+1 L
q2+1
)
rt;i = (1 1 L 2 L2 Lp1 ) !
!(t;i) i + (1 A 1 L A 2 L2 Ap Lp2 ) i
p1 2

35
 Table 6: Comparison of Sample with Simulated Data
Measure Sample Simulation
264:7595
Mean Number of Trades/Day 233:6471
[35 :1139 ]
80:6119
Mean of Duration/Trade 92:7729
[25 :6697 ]
173:6356
St. Dev. of Duration/Trade 189:2438
[77 :3733 ]
0:0304
Mean of Return/Trade 0:0295
[0 :9284 ]
23:7800
St. Dev. Of Return/Trade 21:4329
[2 :9224 ]
Simulate 500 paths of duration and return over a period of one day, calculate mean for each measure as one
estimates. repeat the procedure 500 times to obtain an empirical distribution of the estimators. Mean and
the standard deviation of the estimators are reported.

Figure 1 Daily Seasonality for Duration

1.5
daily seasonality of duration

1.0

0.5

0.0
0 5000 10000 15000 20000 25000

TIME(-1)

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