Ghent Pathology 2011

This study examines the intraday formation process of transaction prices and bid-ask spreads in theKOSPI 200 futures market. By extending the structural model ofMadhavan,Richardson, andRoomans (1997), I develop a unique cross-market model that can decompose spread components and explain intraday price formation for the futures market by using the order flow information from theKOSPI 200 options market, which is a market that is closely related to the futures market as well as considered to be one of the most remarkable options market in the world. The empirical results indicate that the model implied spread and the permanent component of the spread that results from informed trading tend to be underestimated without the inclusion of options market information. Furthermore, the results imply that trades of in-the-money options, which have high delta values, generally incur a more adverse information cost component (the permanent spread component) of the futures market than those of out-of-the-money options, which have relatively low delta values. Finally, I find that the adverse information cost component that is estimated from the cross-market model exhibits a nearlyU-shape intraday pattern; however, it sharply decreases at the end of the trading day.