Volatility forecasting and microstructure noise

It is common practice to use the sum of frequently sampled squared returns to estimate volatility, yielding the so-called realized volatility. Unfortunately, returns are contaminated by market microstructure noise. Several noise-corrected realized volatility measures have been proposed. We assess to what extent correction for microstructure noise improves forecasting future volatility using a MIxed DAta Sampling (MIDAS) regression framework. We study the population prediction properties of various realized volatility measures, assuming i.i.d. microstructure noise. Next we study optimal sampling issues theoretically, when the objective is forecasting and microstructure noise contaminates realized volatility. We distinguish between conditional and unconditional optimal sampling schemes, and find that conditional optimal sampling seems to work reasonably well in practice. © 2010 Elsevier B.V. All rights reserved.