Title: A structural model of market friction with time-varying volatility
Authors: Giuseppe Buccheri - University of Rome Tor Vergata (Italy) [presenting]
Stefano Grassi - University of Rome 'Tor Vergata' (Italy)
Giorgio Vocalelli - University of Rome Tor Vergata (Italy)
Abstract: The problem of extracting the volatility of a financial security is considered when its prices are not frequently updated over time. A model of price formation is proposed in which the observed price varies only if the value of the information signal is large enough to guarantee a profit in excess of transaction costs. Using transaction data only, we extract: (i) the conditional volatility of the underlying security, which is thus cleaned out by market frictions, (ii) an estimate of transaction costs. We apply the model to a large dataset of intraday data. The analysis reveals that, when correcting for transaction costs, the risk of illiquid securities is substantially different from what predicted by traditional volatility models.