High frequency market microstructure noise estimates and liquidity measures

TL;DR

This paper uses advanced econometric methods to separate market microstructure noise from transaction prices, relating it to stock liquidity and exploring a potential market-wide noise factor affecting asset returns.

Contribution

It introduces a novel approach to disentangle microstructure noise from high frequency data and links it to liquidity measures and market-wide factors.

Findings

More liquid stocks have lower microstructure noise.

A market-wide noise factor exists and influences asset returns.

Microstructure noise correlates with liquidity and market conditions.

Abstract

Using recent advances in the econometrics literature, we disentangle from high frequency observations on the transaction prices of a large sample of NYSE stocks a fundamental component and a microstructure noise component. We then relate these statistical measurements of market microstructure noise to observable characteristics of the underlying stocks and, in particular, to different financial measures of their liquidity. We find that more liquid stocks based on financial characteristics have lower noise and noise-to-signal ratio measured from their high frequency returns. We then examine whether there exists a common, market-wide, factor in high frequency stock-level measurements of noise, and whether that factor is priced in asset returns.