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Auction Markets, Dealership Markets and Execution Risk

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Author Info

  • Marco Pagano
  • Ailsa Roell

Abstract

Dealers are suppliers of liquidity; in this respect their role is similar to that played by speculators in auction markets. However, dealers are a special kind of speculator, because of the many obligations and privileges conferred upon them. The most obvious constraint on dealers' behaviour is their obligation to quote firm prices publicly; this implies that, in contrast with what happens on auction markets, traders are insured against execution risk, i.e., the risk of finding few or no counterparty to trade. The normative issue then is: when is it efficient for customers to buy insurance from dealers rather than bearing execution risk themselves? In our model the relevant condition is that dealers must be sufficiently less risk-averse than their customers. The dealership market is superior if dealers are risk-neutral and customers are risk- averse, while it is dominated by the auction market if dealers have the same degree of risk aversion as their customers. There is also an intermediate region of parameter values where the comparison between the two systems is ambiguous: if the fundamental risk of the security is low, the dealership mechanism dominates the auction, while for high-risk securities the reverse is true.

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Bibliographic Info

Paper provided by European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ in its series CEPR Financial Markets Paper with number 0008.

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Date of creation: Nov 1990
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Availability: in print
Handle: RePEc:cpr:ceprfm:0008

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Related research

Keywords: Liquidity; Market Microstructure; Bid-ask Spread; Stock Exchange; Auction Market; Dealer Market;

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Cited by:
  1. Karl Friedrich Habermeier & Andrei Kirilenko, 2001. "Securities Transaction Taxes and Financial Markets," IMF Working Papers 01/51, International Monetary Fund.
  2. Victoria Saporta, 1997. "Which Inter-dealer Market Prevails? An analysis of inter-dealer trading in opaque markets," Bank of England working papers 59, Bank of England.
  3. Goodhart, Charles A. E. & O'Hara, Maureen, 1997. "High frequency data in financial markets: Issues and applications," Journal of Empirical Finance, Elsevier, vol. 4(2-3), pages 73-114, June.
  4. Oehler, Andreas & Unser, Matthias, 1998. "Market Transparency and Call Markets," Discussion Papers 6, University of Bamberg, Chair of Finance.
  5. Marco Pagano, 1998. "The Changing Microstructure of European Equity Markets," CSEF Working Papers 04, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.

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