## Solution to Question 3 from UoL exam 2019, zone A

**(a)** Define the concept of trade duration in financial markets and explain briefly why this concept is economically useful. What features do trade durations typically exhibit and how can we model these features? [25 marks]

High frequency traders (HFT) may trade every millisecond. Orders from traders arrive at random moments and therefore the trade times are not evenly spaced. It makes sense to model the differences

between transaction times. (The Guide talks about differences between times of returns but I don’t like this because on small time frames people are interested in prices, not returns.) Those differences are called **durations**. They are economically interesting because 1) they tell us something about liquidity: periods of intense trading are generally periods of greater market liquidity than periods of sparse trading (there is also after-hours trading between 16:00 and 20:30, New York time, when trading may be intense but liquidity is low) and 2) durations relate directly to news arrivals and the adjustment of prices to news, and so have some use in discussions of market efficiency.

The trading session in the USA is from 9:30 to 16:00, New York time. Durations exhibit **diurnality** (that is, intraday seasonality): transactions are more frequent (durations are shorter) in the first and last hour of the trading session and less frequent around lunch, see Figure 16.6 from the Guide.

Higher frequency in the first hour results from traders rebalancing their portfolios after overnight news and in the last hour – from anticipation of news during the next night.

The main decomposition of durations is

so

In the first equation **de-seasonalized duration** (it has not been defined here). The second follows from the first.

I am not sure that you need the third equation. The fourth equation is used below. In the third equation **polynomial regression**. Both regressions can capture diurnality.

**(b)** Describe the Engle and Russell (1998) autoregressive conditional duration (ACD) model. [25 marks]

Instead of the duration model considered in part (a) Engle and Russell suggest the ACD model

where

The first decomposition is the same as above. The second equation decomposes the de-seasonalized duration into a product of deterministic and stochastic components. To understand the idea, we can compare (1) with the GARCH(1,1) model:

Equations (1) and (2) are similar. The assumptions about the random components are different: in (1) we have

This is important to know, to understand the comparison of the ML method for the two models below.

**(c)** Compare the conditions for covariance stationarity, identification and positivity of the duration series for the ACD(1,1) to those for the GARCH(1,1). [25 marks]

Those conditions for GARCH are

Condition 1:

Condition 2:

Condition 3:

For ACD they are the same, because both are essentially ARMA models.

**(d)** Illustrate the relationship between the log-likelihood of the ACD(1,1) model and the estimation of a GARCH(1,1) model using the normal likelihood function. [25 marks]

Because of the assumption

so

Here

The rest is logical: plug

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