WHERE DO INFORMED TRADERS TRADE CANADIAN SHARES CROSS-LISTED ON U.S. TRADING VENUES? Current Version: December 2005

Transcription

1 WHERE DO INFORMED TRADERS TRADE CANADIAN SHARES CROSS-LISTED ON U.S. TRADING VENUES? Lawrence Kryzanowski and Skander Lazrak 2 Curren Version: December 2005 Ned Goodman Chair in Invesmen Finance. Finance Deparmen, John Molson School of Business, Concordia Universiy, 455 de Maisonneuve Blvd. Wes, Monreal, Quebec, Canada, H3G M8. Telephone: (54) , ex. 2782; lkryzan@vax2.concordia.ca. 2 Assisan Professor of Finance. Deparmen of Finance, Operaions and Informaion Sysems, Faculy of Business, Brock Universiy, 500 Glenridge Avenue, S. Caherines, Onario, Canada, L2S 3A. Telephone: (905) , ex. 53; slazrak@brocku.ca. Financial suppor from he Ned Goodman Chair in Invesmen Finance, IFM2, SSHRC, SSHRC- CREF and SSQRC-CIRPÉE are graefully acknowledged. We would like o hank Abe Brod, Simon Lalancee, and Bryan Campbell and paricipans a he Firs CGA Manioba Finance Conference (Winnipeg, 2005) for heir many helpful commens on earlier versions of his paper. Please do no quoe wihou he auhors permission. Commens are welcomed.

2 WHERE DO INFORMED TRADERS TRADE CANADIAN SHARES CROSS-LISTED ON U.S. TRADING VENUES? ABSTRACT Based on various heoreical models, he sylized predicion is ha he dominan marke in erms of rade aciviy for cross-lised firms will arac all rades. Examining rading and rade behavior for earnings (non)announcemen periods for Canadian firms ha are cross-lised on he TSX and he main U.S. rade venues shows ha he sylized predicion does no hold empirically. Time-varying versions of he Easley e al model for esimaing he probabiliy of informed rading (PIN) and a regime-swiching model for esimaing PINs and decomposing bid-ask spreads are inroduced. Is U.S. compeiors coninue o flourish alhough he TSX is dominan in erms of rade aciviy, has no rade cos advanage in erms of spreads and offers higher marke dephs. Trade venues in boh counries no only have similar PINs during nonannouncemen days bu hey reac simulaneously o earnings news. Since mos (bu no all) informed rading occurs on he Canadian marke for such announcemens, informaion asymmery is reduced on he U.S. marke bu remains unchanged on he TSX. This resuls in he Canadian marke having he greaer informaiveness during earnings announcemen periods. JEL classificaions: G4, G5. Keywords: Iner-lising, informaion asymmery, liquidiy, probabiliy of informed rading, regime-swiching model.

3 WHERE DO INFORMED TRADERS TRADE CANADIAN SHARES CROSS-LISTED ON U.S. TRADING VENUES?. INTRODUCTION Theoreical models of muli-rading venues wih and wihou he presence of asymmeric informaion and in he absence of rapped liquidiy, which are formulaed by Pagano (989), Chowdhry and Nanda (99), Huddar, Hughes and Brunnermeier (999) among ohers, show ha one marke will evenually dominae he oher and arac all rades. These heoreical findings have led o he following sylized predicion. Uninformed raders end o simulaneously rade ogeher on he same venue o reduce he impac of rading on price and o diminish he probabiliy of geing bagged by privaely informed raders. If heir choice of rade venue is based on lowes quoed rade cos, hen his will be an imporan facor in iner-marke compeiion. Given he beliefs of he informed abou he rading behavior of he uninformed, informed raders also will ac sraegically by rading in he more acive rade venue o hide heir rades. This delays he informaional impac of heir cumulaive rades on prices and prolongs heir informaional advanage over he uninformed. In urn, his leads o an equilibrium where one marke should compleely dominae he oher marke(s) and arac all rades. Canadian firms cross-lised on U.S. markes provide a good experimenal seing for esing why his sylized predicion and variaions hereof do no hold in pracice. Thus, he firs quesion (Q) addressed in his paper is: If he TSX dominans in erms of rade aciviy for Canadian shares crosslised in U.S. markes, hen why does he TSX no arac all rades of hese shares? This can be furher decomposed ino wo subquesions: Is he TSX he lowes rade cos venue wih he greaes marke deph (Qa)? If i is, hen why do he U.S. rade venues coninue boh o be viable cross-lising rade venues and meaningful conribuors o he price search or discovery process for Canadian cross-lised socks (Qb)? The firs subquesion is addressed by examining differences in spreads and dephs

4 across rade venues for Canadian firms cross-lised on U.S. markes, while he second sub-quesion is addressed by examining rade aciviy by (un)informed invesors and rade coss for he same sample. To address quesion Qb, we invesigae how and where he (un)informed rade during normal (i.e., nonannouncemen) periods and how his differs for informaion evens. Informed rading is of paricular imporance because i is he porion of all rading aciviy ha has a permanen impac on share prices and reveals privaely held firm-specific informaion o he public. Since informed raders ac o eliminae sufficien-sized deviaions of marke prices from rue fundamenal values (Black, 986), informed raders make an imporan and permanen conribuion o price formaion and discovery (i.e., he informaional efficiency of he marke). Thus, quesion Qb is addressed by examining he more focused quesion (Q2): Where do he privaely informed rade Canadian shares cross-lised on U.S. rade venues, especially during regular ho rading periods associaed wih informaion disclosures? This idenifies he rade venue wih he greaes informaiveness abou he fundamenal values of cross-lised firms. To his end, we analyze he ime-series behavior of he probabiliy of informed rading (PIN) and he cos recovery paymen required by marke makers willing o rade agains poenially informed raders on he compeing rade venues for already cross-lised Canadian firms. Such an analysis allows for a fuller undersanding of where he informed rade firs and how price innovaions are propagaed and impounded ino prices over ime. To beer examine informaional conen or informaiveness, rades and quoes are analyzed around earnings announcemen daes. The choice of his even is no foruious. Firs, no only is rading aciviy usually amplified for maerial corporae announcemens bu public announcemens also have muliple and complex effecs on he pool of acive (un)informed raders and heir rade behaviors. In urn, his provides an empirical opporuniy o observe changes in hese rader pools and heir behaviors on he compeing venues. Secondly and from a mehodological perspecive, earnings announcemens are recurring evens ha have he advanage of increasing he sample size beyond he Krinsky and Lee (996), among ohers, examine changes in spreads around earnings announcemens. 2

5 number of cross-lised firms. 2 Given he ongoing exisence and resilience of he less dominan U.S. markes in erms of rade aciviy for Canadian cross-lised firms, we expec neverheless ha he U.S. rade venues sill play a non-negligible role in erms of price informaiveness, and ha he preponderance of informaion discovery occurs in he Canadian or home rade venue for maerial informaion disclosures. This paper makes hree conribuions o he lieraure. The firs (and main) conribuion is o demonsrae ha he change in he probabiliy of rading agains informed raders (PIN) is asymmeric beween he U.S. and he Canadian markes around he sudied informaion even. The small change in PIN hides several conradicory effecs. Firs, PIN is reduced because informaion disclosure eliminaes he usefulness of previously privae informaion on boh markes. The presence of a larger pool of uninformed raders encourages more raders o become privaely informed (as Noronha, Sarin and Saudagaran (996) also find). However, informed raders do no spli heir rades equally on boh compeing rade venues. They rade more frequenly in he domesic marke compared o heir preannouncemen rading paerns on boh markes. As a resul, PIN declines significanly in he U.S. marke where raders are relaively more paien. The permanen rading cos, which is closely relaed o privae informaion rading, increases upon announcemen on he Canadian marke and is associaed wih higher informed rading aciviy. As a resul, he domesic Canadian marke becomes much more informaive han he U.S. marke for he sample firms. This suggess ha invesors should follow more closely he domesic marke o infer informaion abou fuure price direcion during announcemen windows han during regular (or non-announcemen) periods where boh markes conribue significanly o price formaion. The second conribuion is mehodological. We believe ha we are arguably he firs o implemen a ime-varying or condiional version of he Easley e al. (996) model in order o rack he behaviors 2 The cos of his sample enlargemen is ha saisical ess mus accoun for he loss of independence beween observaions for he same firm. 3

6 of informaion asymmery and PIN around informaion evens, and also he firs o use a regimeswiching model o esimae he ime-varying or condiional componens of he bid-ask spread. 3 The hird and final conribuion is o show ha no unexplainable spread cos advanage exiss among he compeing rade venues, a leas for he firms, evens and periods sudied herein. This suggess ha a Canadian company willing o cross-lis in he U.S. should no use rading coss as a decision crierion for choosing among he hree main U.S. rade venues. Moreover, we find ha he proporional quoed and effecive spreads are no higher on average on he U.S. markes compared o he domesic Canadian marke, couner o wha was repored earlier in he lieraure. This parially explains why he U.S. marke sill aracs rading aciviy and does no vanish. However, he Canadian marke offers higher deph (hickness) compared o he U.S. markes, and is dominan in erms of rade aciviy. This greaer deph aracs boh liquidiy and privaely informed raders o rade on he Canadian marke around maerial informaion evens. As a resul, PIN is similar beween he U.S. and Canadian rade venues for he Canadian cross-lised shares during regular nonannouncemen periods. Since uninformed invesors face he same PIN and rade coss, hey do no shif all heir rades o a single locaion. This explains why boh markes coninue o co-exis for he rade of he shares of he same firms. The remainder of he paper is organized as follows. Secion 2 briefly reviews he relevan lieraure. Secion 3 describes he sample, daa se and basic saisical ess used herein. Secion 4 repors and discusses he resuls for rading aciviy and liquidiy comparisons beween he wo naional markes for he Canadian cross-lised shares. Secion 5 repors and analyzes he ime-varying PIN esimaes from he basic EKOP model. Secion 6 infers he level of informaion asymmery using a regime-swiching model and esimaes he ime-varying PINs and differenials in he spread componens. Secion 7 concludes he paper. 3 Lei and Wu (2005) recenly provide such a framework by assuming ha he arrival rae of uninformed buy orders swiches beween wo levels in a Markov process wih endogenous ime-varying ransiion probabiliies. In conras, Easley e al. (2002) use wo GARCH-ype specificaions for ime-varying arrival raes. 4

7 2. BRIEF REVIEW OF THE RELEVANT LITERATURE 2. Marke Fragmenaion Marke fragmenaion is imporan since i affecs he public ineres via is impac on price discovery (O Hara, 995). Marke fragmenaion poenially can improve rading operaional efficiency hrough iner-marke or venue compeiion, which encourages he members of a rade venue o achieve a beer rading mechanism and o pass he benefis o raders. Fragmenaion also can negaively impac marke efficiency and price discovery (Hamilon, 979). Trading can be revealing as a second componen of informaion, as in Blume, Easley and O Hara (994), since privaely informed raders iniiae a porion of all rades. Since he informaion conen of rading is spli or even los wih fragmenaion, informed raders benefi because hey have more ime o profi from heir nonpublic informaion. If orders are no subjec o an inernaional bes bid and offer (IBBO), hen raders are no guaraneed bes execuion. Furhermore, he marke maker may no have he monopolisic power needed o face informed raders given order-book spliing. Pagano (989) demonsraes ha one marke will evenually dominae he oher and arac all rades based on a model wih muli-rading venues where raders ransac only for liquidiy purposes. Chowdhry and Nanda (99) develop an equivalen bu nonsraegic behavior model and show ha one venue again dominaes in erms of rading volume for he case of shor-lived asymmeric informaion. In such a marke, privaely informed raders spli heir orders sraegically o hide bu rade aggressively o ake advanage of he fragmenaion. However, he exisence of discreionary liquidiy raders leads o an Admai and Pfleiderer (988) concenraed marke. In he absence of rapped liquidiy, Huddar, Hughes and Brunnermeier (999) demonsrae ha all firms lis on he high disclosure exchange o he preclusion of all oher venues. Using a model based on Glosen and Milgrom (985), Madhavan (995) shows ha fragmened markes, where fragmenaion is relaed o he degree of order-flow disclosure, are exploied by large liquidiy raders and by dealers given reduced price compeiion. Furhermore, execuion coss are higher due o he presence of informed raders and he behavior of large raders o rade usually on he 5

8 same side of he marke. Davis and Lighfoo (998) find ha socks rading under rule 9c-3 ha permied off he board rading (marke fragmenaion) had higher spreads han socks under rule 390 ha prohibied such rading (marke concenraion). Benne and Wei (2003) repor ha lising swiches from NASDAQ o NYSE exhibi higher variance reducions and lower execuion coss for more fragmened pre-swich markes. Amihud, Lauerbach and Mendelson (2003) es he value of consolidaion using he expiry of deep-in-he-money warrans (close share subsiues). They repor increased rading volume, lowered implici spreads, and posiive abnormal reurns upon consolidaion (i.e., a warran expiry) due o enhanced liquidiy, and greaer effecs for higher levels of fragmenaion. 2.2 Marke Behavior of Cross-Lised Firms Already Cross-Lised 4 Various papers compare he rade coss of cross-lised firms afer he cross-lising decision. Kryzanowski and Zhang (2002) find ha execuion coss depend on he rade venue for Canadian socks cross-lised on U.S. markes, and ha midspread differences help o explain differenials in execuion coss. 5 They find a reducion in he oal rade cos advanage of he Canadian marke over he U.S. markes afer he ick size reducions in 996 and 997. Ahn, Cao and Choe (998) find ha TSX decimalizaion only affeced (small reducion) spreads of Canadian socks cross-lised on he NASDAQ, and ha U.S. raders did no swich rade venues due o he higher benefis of rading on U.S. markes. Oher papers examine marke-maker paricipaion and he price discovery process for already cross-lised firms. Eun and Sabherwal (2003) find ha generally prices in he U.S. also conribue o 4 Some papers in he rich lieraure dealing wih he impac of iniial cross-lising are of relevance herein. The finding by Sarkissian and Schill (2004) ha cross-lising only reduces home bias minimally suggess ha home bias may be a srong deerminan of he ongoing viabiliy of muli-rading venues for cross-lised firms. Noronha, Sarin and Saudagaran (996) find ha quoed spreads on he U.S. marke do no decrease iniially for U.S. firms cross-lised on he LSE and TSE as he increased compeiion hypohesis would sugges. They aribue his o an increase in informaion based rading (i.e., he aracion of addiional informed rades o he cross-lising venues). Bailey, Karolyi and Salva (2002) find ha volume and rading volailiy increase upon cross-lising for firms making earnings announcemens, alhough firms willingly choose o disclose more informaion o reduce informaional asymmery by cross-lising. 5 Price differences for Canadian cross-lised socks should be arbiraged ou. In conras, perfec arbirage is no possible for ADRs ha are no fully fungible a zero cos due o differenial rading coss and barriers (e.g., Gagnon and Karolyi, 2004). 6

9 he formaion of Canadian prices hrough muual feedback effecs. This raises he unresolved issue of wheher he relaive informaiveness of U.S. and Canadian prices change around maerial informaion evens. Xu and Fung (2002) find similar resuls for Chinese shares cross-lised on he NYSE and he Sock Exchange of Hong Kong (SEHK). Grammig, Melvin and Schlag (2005) find ha, while he majoriy of price discovery ypically occurs in he home marke, price discovery across inernaional markes is no only more complex and richer during rading overlap periods bu ha he role for U.S. price discovery increases as he raio of U.S.-o-home-marke liquidiy increases. Since U.S. and Canadian markes share common opening hours and he raio of U.S.-o-home-marke liquidiy is likely o vary beween informaion- and noninformaion-even periods, his raises he unresolved issue of how price discovery and informaiveness vary beween compeing naional markes for Canadian cross-lised shares. Bacidore and Sofianos (2002) find ha specialis paricipaion is he same for U.S. domesic securiies and Canadian securiies cross-lised on he NYSE. However, hey do no provide evidence on how marke-maker paricipaion varies across compeing naional rade venues for he Canadian shares cross-lised in he U.S. This unresolved issue canno be addressed wihou access o a richer daa se ha idenifies he rades and quoes of he marke makers. 3. SAMPLE, DATA COLLECTION AND BASIC STATISTICAL TESTS Daa on quarerly earnings announcemens are colleced for 72 Canadian firms cross-lised on he U.S. exchanges for he calendar year The earlies announcemen daes for each even are obained by searching he press releases in SEDAR, company websies, he CBCA, Lexis Nexis and Bloomberg. All announcemen daes wih announcemen window overlap for he same company are deleed, where each announcemen window covers 4 rading days cenered on he announcemen dae. Similarly, announcemen daes wih windows during which he sock swiched U.S. lising venue or socks raded a a price below a dollar are deleed. 6 The resuling sample consiss of 493 evens for 35 companies (specifically, 58, 87 and 248 evens on he AMEX, NASDAQ and NYSE, 6 The minimum rade price incremen and board lo size change a one dollar on he TSX. 7

10 respecively). No announcemens occur on he weekend, and no day-of-he-week paern is eviden in he earnings announcemens, alhough mos occur mid-week (80% on Tuesday hrough Thursday). Based on he descripive company saisics repored in Table, Canadian cross-lisings on he NYSE are much bigger han hose on he AMEX and NASDAQ based on all hree size variables. Canadian cross-lisings on he NYSE are raded more heavily on he TSX. Comparisons beween Canadian cross-lisings on he AMEX and NASDAQ are hindered by he more heerogeneous composiion of he AMEX cross-lisings where some big and liquid ouliers shif he mean bu no he median upward. Based on he firs wo digis of he Norh American Indusry Classificaion Sysem (NAICS), mos of hese firms are in manufacuring (56 firms), mining (25 firms) and informaion (2 firms). [Please inser able abou here.] Trading daa are obained from he TSX s Equiy Trades and Quoes Hisory (ETQH) and he TAQ daabases. Record deleion occurs for any quoe or rade ouside of he regular rading hours (9:30 o 6:00 easern ime), open rades, rades wih zero number of shares raded, cancelled or correced rades, rades wih delayed delivery, rades wih special selemen condiions, rades represening a ick ha exceeds 50%, quoes where he bid exceeds he ask price or where eiher equals zero or heir relaive spread exceeds 30%, and quoes posed during a rading hal or on a non- U.S. lising venue (he laer o avoid auoquoe problems, as in Chordia, Roll and Subrahmanyam, 200). 7 The - (Wilcoxon) es is used o deermine if he mean (median) of any measure (or esimae) is saisically differen from zero. Boosrapped p-values are compued o deal wih he lack of independence problem caused by some firms being represened up o four imes in he sample. The boosrapping procedure begins by running a regression of he appropriae measure on a vecor of ones o ge an esimae of he mean measure and is associaed -saisic. To generae he empirical 7 These filers eliminaed % and % of he quoes and rades, respecively, on he TSX, and 0.62% and % of he quoes and rades, respecively, on he U.S. markes. 8

11 disribuion of his -saisic under he null hypohesis, he residuals (mean deviaions) are compued from he regression and hen N samples of pseudo-random residuals are generaed by drawing wih replacemen from he compued residuals. Each sample corresponds o a boosrapped sample of he dependen variable (he measure) under he null since he laer corresponds o he mean being zero. By regressing each of hese N samples on a vecor of ones and compuing he -saisic of each inercep, which is he only explanaory variable, we obain a vecor of N -saisics simulaed under he null hypohesis. The original -saisic is hen insered ino his empirical disribuion o deermine he corresponding p-value from he cumulaive empirical disribuion (Davidson and MacKinnon, 2004; Greene, 2003). For he choice of N (i.e., he number of replicaions), boh a fixed 999 repeiions and alernaively he hree-sep procedure suggesed by Andrews and Bushinsky (2000) are used. 4. TRADING ACTIVITY AND LIQUIDITY OF SAMPLE FIRMS Saisics on he cross-secional disribuions of various rading aciviy and liquidiy measures are repored in able 2. As expeced, he Canadian marke is he rade venue of choice for rades of Canadian cross-lised firms. On average, 302 daily rades [385,703 shares] occur on he U.S. marke versus 46 rades [537,350 shares] on he Canadian marke. The cross-secional mean [median] of he raios of he number of rades in Canada versus he U.S. of 3.95 [.58] implies ha 79.80% [6.24%] of he rades occur in Canada for an average [ypical] cross-lised firm. 8 The marke share of he TSX is even higher using share volume as he measure of rade aciviy. Specifically, he mean [median] raio of Canadian o U.S. share volume of 9.40 [2.0] suggess ha rading on he Canadian marke represens up o 90% [67%] of oal rading. For NASDAQ cross-lised shares, he median [mean] number of rades is lower [higher] in he U.S. The cross-secional average raio of 2.50 and 6.25 for 8 The mean raio differs from he raio of means due o cross-secional variaion in he raios. For he number of rades, he raio of means is.38 (4.6/3.02) while he mean raio (i.e., he cross-secional mean of he raios) is As he variance of he cross-secional raios increases, he difference beween he mean raio and he raio of means widens. For he share volume, he conras is even higher wih a mean raio of 9.40 and a raio of means of.39. 9

12 number of rades and share volume, respecively, indicaes ha he Canadian marke sill capures mos of he rades for an average firm cross-lised on NASDAQ. 9 [Please inser able 2 abou here.] These rade aciviy resuls lead us o address he firs quesion (Q) posed earlier in he inroducion: If he Canadian rade venue dominaes he U.S. rade venues in erms of rade aciviy, hen why does he TSX dominance no lead o he eliminaion of one or more U.S. markes for Canadian cross-lised shares? Is i because he TSX is no he lowes cos rade venue? We answer his laer quesion by firs examining dephs and spread differences beween he wo naional markes for he sample of cross-lised firms. In he heoreical models of Pagano (989) or Chowdhry and Nanda (99), he dominan marke mus a leas be execuion compeiive, and mus be execuion superior o drive ou is compeiors. 0 This condiion implies ha he spread should be a leas compeiive and ha he deph be available. As is eviden from able 2, he TSX offers a deeper marke for raders in he cross-lised firms wih much less cross-secional variabiliy. The mean deph a boh quoes of 2,578 shares on he TSX is significanly higher han he 2,335 shares on he U.S. rade venues, and for he wo venues (NYSE and NASDAQ) ha accoun for more han 85% of our sample. The AMEX generaes much of he crosssecional variabiliy in dephs for he U.S. rade venues. In conras, he mean proporional quoed [effecive] spreads are almos he same a.42% and.44% [.0% and.5%] for he U.S. and Canadian markes, respecively. Based on boosrapped p- values, he mean difference beween he U.S. and Canadian markes of.8 [5.0] basis poins for he quoed [effecive] proporional spread is no significan. The mean effecive proporional spread is 9 Three groups of he NASDAQ cross-lised shares are formed based on heir oal rading volume. For he hinly raded shares, he Canadian marke is highly dominan and represens on average over 9% of oal rading. In conras, for he highly acive issues, he Canadian marke only capures 36% of he volume. 0 Oher reasons beyond cos may explain he long-run susainabiliy of a fragmened marke. These include rapped liquidiy, clienele effec, and differences in invesor preferences and holding periods (e.g., Kryzanowski and Rubalcava, 2005). Ouliers also exis on NYSE and AMEX. For example, he average deph for Norel Neworks is 62,276 shares during he hird quarer of 2002 on he NYSE. This is more han 5 imes he sandard deviaion above he mean of 2,557 shares for all NYSE observaions. 0

13 significanly higher on he domesic Canadian marke (2.28%) han on he U.S. marke (.76%) for Canadian shares cross-lised on he AMEX. 2 Trade cos differences also exis across U.S. lising venues. The mean proporional quoed spreads of 2.45% and 2.2% for respecively he AMEX and NASDAQ are much higher han he 0.57% for he NYSE. The mean proporional effecive spreads exhibi a similar paern wih values close o.76% for boh AMEX and NASDAQ, and a much lower value of 0.42% for he NYSE. 3 As Barclay e al. (999) and Chung, Van Ness and Van Ness (2002) repor, rading coss on NASDAQ declined afer he inroducion of new order handling rules in 997. However, our findings sill show higher coss on he NASDAQ compared o he NYSE for he sample sudied herein. Our conenion is ha hese differences are share- and no exchange-specific since a similar paern emerges for he Canadian-based rades differeniaed by U.S. cross-lising venue for boh absolue and relaive spread measures. To illusrae, he posed proporional spread on he TSX of 0.52% for crosslisings on NYSE is significanly lower han he 2.89% and 2.8% for cross-lisings on AMEX and NASDAQ respecively. A similar conclusion follows based on a comparison of he effecive spreads. A cross-secional regression approach in he spiri of Soll (2000) and ohers is used o es he following hypohesis H 0 : The differences in he various spread measures across he U.S. rade venues are share and no exchange specific. The following cross-secional regression is run o es his hypohesis (as in Harris, 994; Bessembinder, 999; Soll, 2000): spread i = α + α 2 AX i + α3 NSQi + β size + β2 volai + β3 voli + εi () where spread i is he proporional quoed (or effecive) spread for observaion i, and AX and NSQ are dummy variables aking he value of one if he cross-lising is on AMEX and NASDAQ, respecively, and is zero oherwise. The raionale for he choice of hese regressors, already used by ohers in he 2 This is based on all rades regardless of heir order size, rade-side iniiaor, ime of he day and implied probabiliy of informed rading. 3 As expeced, no reflecing he relaion beween rade coss and price level gives a differen inference. Specifically, he unrepored mean posed absolue spreads are 7.77, 7.36 and 4.4 U.S. cens on he AMEX, NYSE and NASDAQ, respecively, and he corresponding unrepored mean effecive absolue spreads are 5.80, 5.46 and.08 U.S. cens. These absolue spreads sugges a much higher cos on he NASDAQ compared o he AMEX and NYSE. The paerns are similar for he medians for boh ypes of spread measures.

14 lieraure, is now discussed. Size is he naural logarihm of oal asses or oal marke capializaion (boh from Compusa), and proxies for adverse informaion. Since he number of financial analyss following a firm and public invesor knowledge should increase wih increasing firm size, ˆβ is expeced o be negaive. Vola is he volailiy as measured by he sandard deviaion of daily sock reurns. Since volailiy capures he price risk of carrying excess or low invenories by marke makers, a posiive 2 ˆβ is expeced as suggesed by he invenory models. Vol is he average daily dollar rading volume (or number of rades). Since volume is inversely relaed o he order processing cos (basically fixed per ransacion), he processing cos per share or per raded dollar is lower wih higher volumes. Therefore, a negaive relaion is expeced beween volumes and spreads, as suggesed by he lieraure. Boh Vola and Vol are measured over he same period as he spread measure. Our primary ineress are ˆα 2 and ˆα 3, which measure he specific addiional cos of he AMEX and NASDAQ markes over he NYSE. The resuls for various formulaions of regression () are repored in able 3. Proporional quoed and effecive spreads are respecively he dependen variables in models {} {4} and {5} {8} for he TSX and correspondingly in models {9} {2} and {3} {6} for he U.S. rade venues. Each block of four regressions uses a mix beween he wo size (measured a calendar year-end) and he wo volume explanaory variables. To reduce he dependence problem by limiing each firm o a solo appearance, only fourh quarer earnings announcemens are used. [Please inser able 3 abou here.] The R-square values of all 6 specificaions are high ranging from 66.7% o 75.%. The β coefficien esimae on he size variable is no significanly differen from zero for Canadian rades using eiher oal asses or marke cap. However, ˆβ is significan in all eigh specificaions wih he prediced negaive sign for U.S. rades. The esimaed β 2 coefficien is significan in all 6 [4] specificaions a he 0% [5%] level wih he prediced posiive sign. This confirms he conjecure ha marke makers widen spreads o self-proec agains higher volailiy and hence higher probabiliy of 2

15 ruin. The esimaed β 3 coefficiens are significanly differen from zero wih he prediced negaive sign in all specificaions. This suggess ha spreads are closely relaed o rading volumes, and ha he order processing cos which is parly linked o rading volume is an imporan componen of rading coss. The ˆα 2 and ˆα 3 provide evidence agains exchange-specific effecs, as we conjecured earlier. Firs, he AMEX impac on posed proporional spreads is significan and posiive for he U.S. based rades, and ranges from 4.96 o 5.45 basis poins for he four specificaions. This represens he excess rading cos on he AMEX in comparison o he NYSE afer conrolling for share-specific facors. However, his exra cos is absen when he effecive proporional cos is considered. In conras, and like cross-lisings on NASDAQ, cross-lisings on AMEX have nonsignifican differences in rading coss for Canadian based rades and quoes. Second, no significan exchange effec occurs for shares cross-lised on NASDAQ for 3 ou of he 6 specificaions a he 5% confidence level. Thus, he higher overall rading coss for cross-lisings on NASDAQ and o a lesser exen AMEX are due primarily o smaller firms ha are subjec o higher adverse selecion, less liquid companies wih higher per rade order processing coss, and riskier companies leading o higher invenory risk for marke makers. We now have he following parial answer o he firs quesion (Q) posed in he inroducion. The TSX dominance in erms of rade aciviy does no lead o he eliminaion of one or more U.S. markes for Canadian cross-lised shares because all markes offer similarly low rade coss for average rade sizes for (especially liquidiy) raders. This follows from he spread and deph comparisons where he wo naional markes are generally comparable in erms of spreads while he Canadian marke offers greaer deph. Neverheless, he lower deph available on he U.S. marke appears o be sufficien o fill a large number of ransacions herein. To provide some iniial insighs ha he rade behavior of he rader pool differs beween naional markes and changes around earnings announcemens, he proporion of execuions agains limi 3

16 orders (PEALO) is now examined. Given he longer holding periods (higher share urnover) documened by Kryzanowski and Rubalcava (2005) for U.S. rade venues, a lower PEALO is expeced on U.S. rade venues. Since more paien invesors are more likely o submi limi orders when hey do decide o rade, hey are less likely o have heir rades execued agains he sanding BBO. As in Easley, O Hara and Saar (200), PEALOs are inferred using he Greene (997) algorihm. Based on he enire 4-day (38-day nonannouncemen) window, PEALOs are higher in he Canadian han he U.S. markes (respecively, 77% and 4% for number of rades and 58% and 34% for share volume), probably because he represenaive rader is less paien on he TSX, as noed above. This can resul, for example, from a greaer proporion of he execued orders in U.S. markes resuling from more aggressive limi order submissions (i.e. wihin he ousanding BBO) ha are mached rapidly, and hus, are no couned as execuions agains (BBO) limi orders using he Greene algorihm. PEALO changes ha occur upon earnings announcemen also are examined since such maerial evens affec he price level and conain an elemen of surprise ha increases volailiy and hereby may affec he relaive proporion of submied limi orders (Handa and Schwarz, 996; Foucaul, 999). The even-induced change in PEALO will be upwards, nil or downwards depending upon wheher hese new limi orders are a, away or wihin he naional BBO and are subsequenly execued agains marke orders. The PAELO drops by an insignifican 72 basis poins for he TSX and by a significan 5 basis poins on U.S. rade venues for he hree-day announcemen window. The significan decline in he U.S. implies ha uninformed raders in ha marke become more aggressive as hey are less likely o rade agains informed raders upon earnings announcemen, as is shown in he nex wo secions. 5. PIN CHANGES FROM A TIME-VARYING EKOP MEASURE We now address he second quesion posed in he inroducion; namely: Where do he privaely informed rade Canadian shares cross-lised on U.S. rade venues, especially during ho rading periods associaed wih informaion disclosures. To his end, he following wo hypoheses are esed: 4

17 H 2a 0 : The PINs are he same in he U.S. and Canadian markes for he cross-lised shares. H 2b 0 : The PINs change around quarerly earnings announcemen daes in an asymmeric manner for he compeing naional rade venues. 2 Our expecaion for H is ha he compeing cross-lising rade venues can co-exis if he PINs a 0 are he same across venues or ha hey can slighly differ provided he effecive spreads do no. Furhermore, if hey do differ, we expec ha he PIN for he Canadian marke is lower given is wider 2b pool of uninformed raders due o is marke dominance. Our expecaion for H is ha he respecive PINs are likely o change upon announcemen due o a changing mix of (un)informed raders on he differen naional rade venues, and ha he direcion of his change is indeerminae and downwards for he Canadian and U.S. rade venues respecively. The indeerminae PIN change for he Canadian marke is because he increase in informed rading on his marke may be more or less offse by an increase in uninformed rading. The downward PIN change for he U.S. markes is due o he migraion of mos informed rading o he Canadian marke upon earnings announcemen o ake advanage of he deeper marke. The PINs are obained using a condiional version of he Easley, Kiefer, O Hara and Paperman or EKOP (996) mehodology. 4 To obain a ime varying daily PIN measure, each day is spli ino 78 successive inervals of five-minues lengh, and he rades in each inerval are reaed as a single block. Ten samples are consruced where each sample conains eigh rading blocks excep for he ninh and he enh ha conain seven rading blocks each. Block assignmen is conduced sysemaically on a rolling basis. The firs block ha covers he ime period of 9:30 o 9:35 a.m. is assigned o he firs sample. The second block ha follows immediaely is assigned o he second sample and so on. This design suffers from fewer problems han oher alernaives in ha no only are blocks of rades kep 0 4 EKOP use maximum likelihood o esimae he probabiliy of an even occurring over a given number of days based on he argumen ha his probabiliy is eiher one or zero for each day and canno be inferred direcly. EKOP also assume ha, if an even akes place, he even occurs before rading sars for ha rading day. 5

18 ogeher bu also every sample conains blocks spread hroughou he rading day. 5 Assigning individual rades randomly o samples would ignore he fac ha he marke maker may be able o infer poenial privae informaion from he ime-series behavior of buy and sell orders and adjus quoes accordingly. Furhermore, he inerval needs o be long enough o capure divided orders. This is suppored by he observaion ha successive rades wih he same sign and rader ID for our sample are execued wihin 5 seconds for over 97% of he rades. The logic behind he EKOP model is ha he arrival of informed and uninformed raders o he marke place on day follows a Poisson process wih inensiy parameers of µ and ε, respecively. For every sample i on day, we observe B i, buyer-iniiaed rades and S i, seller-iniiaed rades using he Lee and Ready (99) algorihm, he probabiliy of even occurrence is α, and he condiional probabiliy ha he even has a negaive impac on he sock is δ for day. Dropping he subscrip for convenience, he likelihood of observing B i and S i condiional on informaion se Θ is given by: ( δ ) ( ) ( + ) ( µ ε ) ( µ + ε ) Bi Si Bi ε ε ε ε ε ε + L ( Bi, Si ) Θ = ( α ) e e + αδ e e B! S! B! S! + α e i i i i B i Si µ ε ε e B! S! µ + ε ε i i Si (2) The firs erm in (2) corresponds o he case of a sample wih no news evens (i.e., all raders are uninformed). The second and hird erms are linked o bad and good even samples, respecively. The parameer vecor o be esimaed using a daa se consising of he numbers of buys and sells is Θ = ( α, δ, ε, µ ). In EKOP, α and δ are consrained o be inside he inerval [ ] ransformaion, and ε and µ are resriced o be posiive by a logarihmic ransformaion. 0, hrough a logi Over he en daily samples ha are assumed o be independen, he likelihood funcion is: 0 i i Θ (3) i= (, ) Θ = ( ; ) L B S L B S 5 Samples formed successively during he rading day also are used. The rade clusering phenomenon well documened in he lieraure wih periods of high rading volume (such as he morning session and he end of he rading day) and periods of low rading volume (like he midday) cause he samples from his sampling design o be quie differen. In urn, his leads o erroneous inferences. 6

19 This funcion is maximized using several numerical mehods and several saring poins o avoid being rapped in a local maximum. 6 The parameer of ineres is he condiional probabiliy of informed (PIN) rade, which is given by: PIN α µ α µ + 2ε = (4) Before discussing he resuls, noe ha he esimaes are likely o be poor if a sock is hinly raded. To illusrae, assume ha a single daily rade occurs ha is buyer iniiaed so ha all he five minue inervals bu one conains an observed pair of (0,0) and he sole excepion conains he enry (,0). Maximizing he logarihm of (3) in his case is rivial, and will force he dela parameer o a value of zero. For his reason, 32 observaions are reained for furher analysis because hey exhibi a leas five rades per day for each period. The empirical esimaes for he inra-daily EKOP model and a more sandard iner-daily version are repored in Table 4. The median probabiliy of an even occurring as measured by α is 34.33% and 35.00% based on U.S. and Canadian rades, respecively. These values are no saisically differen based on he boosrapped p-value. This resul conforms o a priori expecaions since no differences in even occurrence or heir probabiliies of occurrence should exis for he same socks over he same ime periods. The significan difference for AMEX rades is caused by a few ouliers, especially for Bema Gold during he fourh quarer of he year Thus, he median alphas of 3.86% and 33.0% based on he Canadian- and U.S.-based rades, respecively, for he AMEX cross-lisings are no significanly differen. [Please inser able 4 abou here.] The probabiliy of a negaive even given by he esimaed δ parameer is significanly lower by 3.89% for U.S. rades han for Canadian rades. Furhermore, he esimae is significanly differen (lower) only based on rades from NASDAQ and NYSE. As is shown subsequenly, his resul is 6 These include he Newon and Quasi-Newon algorihms (as developed by Broyden, Flecher, Goldfarb, and Shanno, and by Davidon, Flecher, and Powell), a combined Quasi-Newon wih a Line search wih analyic derivaion of he gradien and he Hessian, and he Hill-Climbing algorihm of Quand as used by EKOP. 7

20 consisen wih differences in informed rader paricipaions as refleced in he differences in he PINs beween various ses of compeing rade venues. Based on he median daily number of rades, uninformed invesors rade more inensively on he Canadian (60.0) versus he U.S. rade venues (28.94). However, he mean of he raios of numbers of rades on he Canadian versus U.S. rade venues of 4.33 repored in able 4 suggess ha cases exis where pracically all uninformed rading akes place on he Canadian marke. To illusrae, Noranda Inc, which is cross-lised on he NYSE, has a raio of ha indicaes ha 98% of is uninformed rading occurs on he TSX. Similar resuls occur for informed rading inensiy. Based on he second row of able 4, he median number of daily informed rades condiional on even occurrence is significanly higher on he Canadian rade venue (47.57 versus in he U.S.). Their respecive mean and median raios of 2.63 and.9 are significanly differen from one overall, and for he NASDAQ and NYSE and no AMEX. Thus, according o expecaions, informed raders rade more inensively on he Canadian rade venue. Given ha he probabiliy of even occurrence is he same for he U.S. and Canadian markes and ha boh liquidiy and informed rading aciviy are higher on he Canadian rade venue and ha he Canadian-o-U.S. marke raios are larger for liquidiy- versus informaion-based rades, we expec ha PIN is lower on he Canadian marke according o expression (4). Based on able 4, a small bu saisically significan lower mean PIN parameer difference of 256 basis poins exiss beween he Canadian and U.S. rading venues (8.39% versus 20.95%). This is consisen wih our a priori 2a expecaions for H in ha he difference is very small. Lising venue-specific differences also occur 0 for his meric. For example, he mean PIN is higher on he TSX han he AMEX (27.20% and 20.75%, respecively). This is mos likely due o greaer marke hinness on he AMEX, which reduces he abiliy of he informed o hide heir rades. 8

21 The rading paerns of boh rader ypes around he quarerly earnings announcemens now are examined furher. Our expecaion is ha he informed sar rading on he main marke, which is usually he Canadian rade venue, and hen spli heir rades beween he fragmened markes o exend heir advanage. Based on he findings of Eun and Sabherwal (2003), we expec he Canadian marke o be mos informaive and he U.S. marke o make a maerial (bu more mued) conribuion o price discovery since he privaely informed also rade on he U.S. marke. An analysis of he plo of he inra-daily EKOP esimaes given in Figure suppors our expecaion and helps o explain he origins of he coexisence of he wo naional markes for crosslised shares. Since he expecaion is ha pre-announcemen days are characerized by informed rading, when informed rade firs begins and how i moves over ime for he wo compeing rade venues is of ineres. Panel A of figure depics he ime-series of mean and median α esimaes and he 95% confidence inerval around he mean for boh he U.S. and Canadian rades. All he x-axes are cenered on day zero or he earnings announcemen dae. 7 The graph for he U.S. rades documens a clear increase in he probabiliy of even occurrence on day zero o a mean [median] peak value of 60.55% [60.20%]. In conras, a seady decline in α begins abou four days prior o he announcemen for he Canadian rades. The inra-daily mean is significanly higher in value han is iner-day counerpar essenially due o he added noise caused by greaer daa frequency. 8 [Please inser figure abou here.] Based on panel B in figure, a very shor-lived decline occurs on boh he Canadian and U.S. markes a he announcemen dae for he dela parameer (i.e., he probabiliy of a negaive even). No difference exiss beween he iner-daily and inra-daily esimaes for dela. Based on panel C, he mos dramaic changes occur in he rading inensiy parameers. Informed rading inensiy increases by differen magniudes on U.S. (more mued) and Canadian rade venues around he earnings 7 The confidence inerval is compued as he mean plus and minus wice is sandard deviaion. If he disribuion is skewed and he variance around he mean is low as he number of observaions is high, he median can lie ouside he confidence inerval for he mean. Panels C, D and E of figure exhibi his case. 8 The cross-secional ime-series average alpha parameers over he enire ime period are 58.92% and 54.70% for he U.S. and Canadian markes, respecively. 9

22 announcemen days. The increase in he rading inensiy of informed raders sars abou hree days prior o he announcemen for he Canadian marke and peaks on day one a rades. Based on panel D, no differences exis in he ime series paern of he inensiy parameers (ε) of he uninformed beween he wo naional markes. Boh markes exhibi a clear and sudden jump in uninformed rading ha corresponds wih he earnings announcemen. Uninformed rades peak a daily values of 87.0 and 24.2 on he U.S. and Canadian markes, respecively. 9 If he peak period values are excluded, he respecive mean ε esimaes become 26.9 and These rades are due o porfolio rebalancing afer informaion release, o rades based on he belief ha prices do no compleely reflec he informaion released, o rades based on he observaion of higher rading volumes, and o rades based on noise perceived o be informaion (Black, 986). Given ha he alpha parameer increases slighly upon earnings announcemen and ha he uninformed raders increase heir rading more han he informed, he expecaion is for a lower PIN because of rader pool diluion creaed by he relaively larger increase of uninformed han informed raders. Based on Panel E of figure, his conjecure is confirmed as he mean PIN on he U.S. marke drops from 4.05% wo days before he earnings announcemen o 37.25% on he day afer he earnings announcemen. Similarly, he PIN on he Canadian marke falls from 37.20% o 34.96% over he same period. As for he iner-daily esimaions, he PIN esimaes for he inra-daily EKOP are slighly lower on he Canadian versus U.S. markes. Thus, even if he number of informed raders or heir rading aciviy is more inense on he Canadian marke, he mere presence of more uninformed rader aciviy reduces he probabiliy ha he counerpar is indeed a privaely informed rader for a specific rade iniiaed by an uninformed rader. Since he PIN decline can be raced o he day before he earnings announcemen for boh compeing markes, we canno conclude ha eiher marke is firs in erms of price discovery. This issue is revisied in he nex secion of he paper. 9 The daily figures are higher han hose esimaed from he iner-daily version of 40 and 96 liquidiy moivaed rades per day for U.S. and Canadian marke venues, respecively, which were presened earlier in able 4, because he inra-daily analysis is based on more liquid shares. 20 Figure shows he resuls per inraday ime inerval. Since 0 samples are consruced daily, he daily rading inensiies are equal o he corresponding inraday values muliplied by 0. 20

23 6. PIN AND SPREAD COMPONENT CHANGES FROM A REGIME-SWITCHING APPROACH In his secion, he daily probabiliy of informed rading (PIN) is inferred from U.S. and Canadian based rades for Canadian shares cross-lised on he main U.S. exchanges using an alernae esimaion mehod o beer idenify where he informed rade firs a he announcemen and where mos of he informaion is firs embedded ino he price. The implied quoed spread also is decomposed ino is emporary and permanen componens. An increase [decrease] in he permanen cos (i.e., compensaion for rading agains informed raders) implies ha he loss o informed raders is higher [lower] and ha here are relaively more [less] informed raders in he markeplace. 6. Models and Mehodology Our approach is similar o ha used by Nyholm (2003) for 20 NYSE-lised shares for Augus 995 in ha our model is based on Glosen and Harris (988). However, unlike Nyholm, rading coss are direcly dependen on rading volumes for hree rade size caegories. To develop he model, we firs assume ha he rue asse price, m, follows he moion equaion given by: m = m + I Z s + e (5) where I is he rade indicaor a ime (- for seller iniiaed, and + for buyer iniiaed), Z is he adverse informaion cos given ha he rade is informaion based, which has a permanen impac on he rue price of he asse, s is a sae variable relaed o he naure of he rade, which is perfecly observable o he marke maker and no o he economerician, and is equal o for informaion-based rades and o 0 oherwise (i.e., for purely liquidiy-based rades), and e is relaed o he public news released during he inerval beween - and. Once he rue price is se, he marke maker ses ransacion prices o recover her own order processing fees using he following pricing mechanism: 2

24 where P = m + I C (6) C is he order processing cos (i.e., he emporary componen of he bid-ask spread), and all oher erms are as defined previously. Given he rue price moion (5) and he pricing funcion (6), he change in price beween ime - and is compued using: = I Z s + I C I C e (7) dp + In (7), dp depends on he sae variable s. The change in he ransacion price is dp = I Z + I C I C + e if an informed rader iniiaes he ransacion, oherwise he marke maker changes he ransacion price by dp = I C I C + e. Since Glosen and Harris (988) assume ha boh C and deerminan of he rading cos. 2 Z are relaed o he size of he ransacion a ime, size is used as a Based on he findings of Barclay and Warner (993), Chakravary (200), among ohers, on sealh rading and he associaion of medium-size rades wih informed rades, rades are divided ino hree caegories ha are expeced o have differen marginal price impacs. Small rades are hose involving 500 or less shares, as in Barclay and Warner (993), Chakravary (200), and Koski and Michaely (2000). Medium-size rades are ransacions of 50 o 5,000 shares, and large rades are ransacions of 5,00 shares and more (e.g., as in Bessembinder, 2003; Koski and Michaely, 2000; SEC rule Ac -5). Since block rades on he NYSE and NASDAQ are defined as rades of 0,000 shares and more, his would be a naural definiion of a large rade. This break poin is no adoped herein because block rade delineaion should depend on share price and rading aciviy (Bessembinder and Venkaaraman, 2005). For he sample under invesigaion, no ransacions of more han 0,000 shares occur for some firms, especially for rades on NASDAQ. Hence, we have: 2 Nyholm uses a fixed cos per size caegory. We argue ha since he cu off poins are arbirary, allowing size variabiliy wihin each class can alleviae he classificaion problem, especially for he medium size rades ha are considered as he ones wih he highes proporion of informed rading. 22