Reputation-based pricing and price improvements in dealership markets
AbstractIn many security markets, dealers trade with their regular clients at a discount relative to prevailing bid and ask quotes. In this article we provide an explanation to this phenomenon. We consider a dealer and an investor engaged in a long-term relationship. The dealer assigns a reputational index to his client. This index increases (reputation decreases) when the client conducts trades which results in a loss for the regular dealer. The dealer grants a price improvement if and only if the client's index is smaller than a threshold and suspends price improvements otherwise. We show that this pricing strategy induces the investor to refrain from exploiting private information against her regular dealer. We also find that it worsens the quotes posted by other dealers. For this reason, there are cases in which the investor is better off if long-term relationships are impossible (for instance, if trading is anonymous). Our model predicts that a dealer's decision to grant a price improvement depends on his past trading profits with the trader requesting the improvement.
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Bibliographic InfoPaper provided by HEC Paris in its series Les Cahiers de Recherche with number 716.
Length: 48 pages
Date of creation: 01 Apr 2000
Date of revision: 01 Mar 2002
Market microstructure; Reputation and Implicit contracts; Non-Anonymous trading;
Other versions of this item:
- Desgranges, Gabriel & Foucault, Thierry, 2002. "Reputation-Based Pricing and Price Improvements in Dealership Markets," CEPR Discussion Papers 3359, C.E.P.R. Discussion Papers.
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
- L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
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