Price discovery and common factor models

If a financial asset is traded in more than one market, common factor models may be used to measure the contribution of these markets to the price discovery process. We examine the relationship between the Hasbrouck (J. Finance (50) (1995) 1175) and Gonzalo and Granger (J. Bus. Econ. Stat. 13 (1995) 27) common factor models. These two models complement each other and provide different views of the price discovery process between markets. The Gonzalo and Granger model focuses on the components of the common factor and the error correction process, while the Hasbrouck model considers each market's contribution to the variance of the innovations to the common factor. We show that the two models are directly related and provide similar results if the residuals are uncorrelated between markets. However, if substantive correlation exists, they typically provide different results. We illustrate these differences using analytic examples plus a real world example consisting of electronic communications networks (ECNs) and other Nasdaq market makers. (C) 2002 Elsevier Science B.V. All rights reserved.