A model of price discovery and market design: Theory and empirical evidence

Abstract

Price discovery is an essential function performed by derivative markets. For a derivative exchange, its markets' ability to incorporate information into prices to "derive" the underlying asset's value is a key objective of market design. The J. Hasbrouck (1991a) model is applied to examine the design and price discovery of a futures market. First, the model is extended to consider a comprehensive dynamic interaction between the pricesize coordinates of orders and trades. Second, floor and screen tick data from LIFFE's FTSE 100 index futures market is used to estimate the two models. The significance of order size variables in the extended model suggests that order flow transparency, which is supported by an electronic trading platform, improves price discovery. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:1107-1146, 2004 "The microstructure literature analyses how specific trading mechanisms affect the price formation process . . . and the process by which markets become efficient." O'Hara (1995, Chapt. 1, p. 1) This paper combines a theoretical and an empirical chapter from my Ph.D. thesis. Data funding support from the Department of Finance, Melbourne University is gratefully acknowledged. I thank Kim Sawyer and Christine Brown for their continuous assistance and support. I retain full property rights to all errors. For correspondence, Department of Accounting and Finance, Monash University, Clayton, VIC 3800, Australia; e-mail: michael.chng@buseco.monash.edu.au Received February 2004; Accepted June 2004 I Michael T. Chng is in the Department of Accounting and Finance at MonashUniversity in Clayton, VIC, Australia. The Appendix contains a list of all acronyms used in this paper. 2 For example, competition of order flow in cross-listed securities among stock exchanges, and contract proliferation among futures exchanges. INTRODUCTIONIn a general sense, market microstructure, which focuses on the analysis and comprehension of the data generating process of capital markets, matters to all empirical finance research. It matters to market participants by providing invaluable insights into the operation of capital markets, the intra-day price behavior of security prices and the welfare distribution to distinct investor clienteles. The latter point is demonstrated in the investigation by Christie and Schultz (1994) on NASDAQ 1 dealers. Market microstructure is also relevant to a financial exchange that hosts and regulates its markets' trading procedures, the quality and integrity of which contain direct competitive implications. This is relevant in the context of multiple trading venues.2 Such competitive forces are particularly acute when the trading hours of alternate venues overlap and when the geographical proximity of traders ceases to pose a barrier to trade. Both are increasingly true with technology facilitating access to trading platforms from across vast distances and time zones.From an exchange's perspective, issues in market microstructure are basically questions in market design. Policy makers ar...

Order Imbalance in the FTSE Index Futures Market: Electronic versus Open Outcry Trading

“…Gilbert and Rijken (2006) report that the number of contracts per trade after automation is only one-third of its open outcry level. Moreover, Chng (2004) finds that screen trades are serially correlated while floor trades are not.…”

“…A trading agent who demands immediacy could submit the market order(s) against the electronic limit order book in two ways. First, a large market order, either purchase or sale, is executed against a series of existing quotes (Chng, 2004;and Gilbert and Rijken, 2006). Alternatively, strategic traders could exercise computer algorithms to automatically split a large market order into many smaller pieces, which either hit an existing limit order of comparable size or multiple smaller size orders.…”

“…on the book (Chng, 2004;and Gilbert and Rijken, 2006). Alternatively, if computer algorithms are exercised to automatically split a large market order into smaller pieces, these trades could either hit a comparably sized standing limit order or many smaller sized orders.…”

The informational impact of electronic trading systems on the FTSE 100 stock index and its futures contracts

“…Frino and McKenzie (2002) also study the impact of LIFFE CONNECT and conclude that the strengthening of the simultaneity of price discovery probably reflects that the cash market is also screen traded, which enhances program trading and index arbitrage. Chng (2004) finds that electronic trades at LIFFE CONNECT are more than twice as informative as the previous floor trades and concludes that this is originated by the increase in the order flow visibility. Hasbrouck (2003) examines the relative price discovery of exchange-traded funds, regular futures contracts, traded through open outcry at CME, and E-mini futures contracts, screentraded at GLOBEX, on the S&P 500 and NASDAQ 100 indices and estimates information shares of around 85% for the E-mini contract.…”

The Informativeness of Trades and Quotes in the FTSE 100 Index Futures Market

“…However, if the index futures market attracts informed traders, then these markets complete the underlying cash market and add to its price discovery and efficiency . Indeed, several studies have examined the informativeness of trades in index futures markets and in particular for the FTSE 100 index futures (see, e.g., Chng, ; Holmes & Tomsett, ). These studies suggest that trades in the FTSE 100 futures contract are informative and contribute to a large proportion of the innovation in the efficient price.…”