Modeling the Epps effect of cross correlations in asset prices

Details Modeling the Epps effect of cross correlations in asset prices Modeling the Epps effect of cross correlations in asset prices

2007-04-28

arxiv.org/abs/0704.3798v1

Proc. SPIE, Vol. 6601, 66010J (2007)

Economy

Quantitative Finance

Statistical Finance

to appear in the Proceedings of SPIE Fluctuations and Noise 2007

Scientific paper

10.1117/12.727127

We review the decomposition method of stock return cross-correlations, presented previously for studying the dependence of the correlation coefficient on the resolution of data (Epps effect). Through a toy model of random walk/Brownian motion and memoryless renewal process (i.e. Poisson point process) of observation times we show that in case of analytical treatability, by decomposing the correlations we get the exact result for the frequency dependence. We also demonstrate that our approach produces reasonable fitting of the dependence of correlations on the data resolution in case of empirical data. Our results indicate that the Epps phenomenon is a product of the finite time decay of lagged correlations of high resolution data, which does not scale with activity. The characteristic time is due to a human time scale, the time needed to react to news.

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