Abstract - International Price Discovery in the Presence of Market Microstructure Effects

This paper addresses and resolves the problems caused by microstructure effects when measuring the relative importance of home and U.S. market in the price discovery process of Canadian interlisted stocks.Previous studies applying the Cholesky decomposition within the Hasbrouck (1995) framework faced the following dilemma: on the one hand, at low frequencies information share bounds diverge considerably, rendering the midpoint between the bounds a rather unreliable proxy for the true information share. On the other hand, we show in a simulation study that information shares are biased at very high frequencies due to market microstructure effects. Our modified approach offers a solution to this dilemma. Following Lanne and Luetkepohl (2005),we rely on distributional assumptions for identification. Our method yields unique and unbiased information shares. We examine a sample of 69 Canadian stocks, which are listed on the Toronto Stock Exchange and cross-listed on the New York Stock Exchange. Our results indicate that the role of the U.S. market in the price discovery process of Canadian interlisted stocks has been underestimated so far. Rather than a clear home market leadership as found by previous study, our results imply that price discovery is nearly evenly distributed between home and foreign market. Moreover, we find a surprisingly small cross-sectional variation of our modified information shares. This suggests that contributions to price discovery are determined by market characteristics rather than by stock specific factors. Thus, by the design of their trading protocol, national stock exchanges themselves are able to influence the role they play within the price discovery process of interlisted stocks and use this to their advantage when facing the threat of the large international exchanges. 

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