Estimating overnight volatility of asset returns by using the generalized dynamic factor model approach

This paper proposes a new approach to estimate the overnight volatility of an individual stock return. Since markets generally do not trade during the overnight period, measures of realized volatility cannot be computed on a “high-frequency” basis. Some studies have resorted to using the square overnight return as a proxy for the overnight realized volatility, but this measure is typically very noisy. The new estimator of the overnight volatility proposed is obtained using the generalized dynamic factor model. The performance of the new proxy is examined using simulated data. This is found to perform better than the squared overnight return. Empirical analysis of the S&P100 constituents confirms the potential of this proxy.