The price formation of substitute markets: Theory and empirical application

Two related issues are seldom jointly addressed in the cross market price discovery literature: i) a model that focuses on non-price parameter, ii) testing a non-price parameter model against a price parameter model. We have two objectives in this paper. First, develop a joint trade direction model (JTDM) from the single market model in Madhavan, Richardson and Roomans (1997). Second, estimate and test the JTDM against the Gonzalo and Granger (1995) VECM measure of price discovery. By doing so, we test the relevance of trade direction against quote change in cross-market price formation. The estimation of 20 Chinese twin-board rms reveal i) VECM and JTDM generate consistent ranking in 4 out of 10 A-H rms and 2 out of 10 A-B rms, all of which provide strong evidence of price discovery by the H or B boards; ii) Where VECM and JTDM generate con icting rankings in 6 A-H rms, the Wald test and/or J-test rejects VECM in favor of JTDM; iii) Where VECM and JTDM generate con icting rankings in 8 A-B rms, the Wald test and J-test rejects VECM (JTDM) in favor of JTDM (VECM) for 2(3) rms; neither model nor model selection tests are able to decide which board is more informative in 3 A-B rms. The less consistent results in the A-B sample group is not surprising given that the A and B boards were implicitly merged in 2001-2002. JEL classi cation: G14, G15.