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Reputation-based pricing and price improvements in dealership markets

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Author Info
DESGRANGES, Gabriel (Thema ; Université de Cergy)
FOUCAULT, Thierry

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Abstract

In 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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Publisher Info
Paper provided by HEC Paris in its series Les Cahiers de Recherche with number 716.

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Length: 48 pages
Date of creation: 01 Apr 2000
Date of revision: 01 Mar 2002
Handle: RePEc:ebg:heccah:0716

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Postal: HEC Paris, 78351 Jouy-en-Josas cedex, France
Web page: http://www.hec.fr/
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Related research
Keywords: Market microstructure; Reputation and Implicit contracts; Non-Anonymous trading;

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Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
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

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. Dow, James, 1998. "Arbitrage, Hedging, and Financial Innovation," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 11(4), pages 739-55.
  2. Dan Bernhardt & Vladimir Dvoracek & Eric Hughson & Ingrid M. Werner, 2005. "Why Do Larger Orders Receive Discounts on the London Stock Exchange?," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 18(4), pages 1343-1368. [Downloadable!] (restricted)
  3. Kreps, David M. & Wilson, Robert, 1982. "Reputation and imperfect information," Journal of Economic Theory, Elsevier, vol. 27(2), pages 253-279, August. [Downloadable!] (restricted)
    Other versions:
  4. Radner, Roy, 1985. "Repeated Principal-Agent Games with Discounting," Econometrica, Econometric Society, vol. 53(5), pages 1173-98, September. [Downloadable!] (restricted)
  5. Battalio, Robert & Jennings, Robert & Selway, Jamie, 2001. "The potential for clientele pricing when making markets in financial securities," Journal of Financial Markets, Elsevier, vol. 4(1), pages 85-112, January. [Downloadable!] (restricted)
  6. Benveniste, Lawrence M. & Marcus, Alan J. & Wilhelm, William J., 1992. "What's special about the specialist?," Journal of Financial Economics, Elsevier, vol. 32(1), pages 61-86, August. [Downloadable!] (restricted)
  7. Madhavan, Ananth, 2000. "Market microstructure: A survey," Journal of Financial Markets, Elsevier, vol. 3(3), pages 205-258, August. [Downloadable!] (restricted)
  8. Glosten, Lawrence R, 1989. "Insider Trading, Liquidity, and the Role of the Monopolist Specialist," Journal of Business, University of Chicago Press, vol. 62(2), pages 211-35, April. [Downloadable!] (restricted)
  9. Seppi, Duane J, 1990. " Equilibrium Block Trading and Asymmetric Information," Journal of Finance, American Finance Association, vol. 45(1), pages 73-94, March. [Downloadable!] (restricted)
  10. Madhavan, Ananth & Cheng, Minder, 1997. "In Search of Liquidity: Block Trades in the Upstairs and Downstairs Markets," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(1), pages 175-203.
  11. Madhavan, Ananth, 1992. " Trading Mechanisms in Securities Markets," Journal of Finance, American Finance Association, vol. 47(2), pages 607-41, June. [Downloadable!] (restricted)
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  12. Benabou, Roland & Laroque, Guy, 1992. "Using Privileged Information to Manipulate Markets: Insiders, Gurus, and Credibility," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 921-58, August. [Downloadable!] (restricted)
    Other versions:
  13. Biais, Bruno & Glosten, Larry & Spatt, Chester S, 2002. "The Microstructure of Stock Markets," CEPR Discussion Papers 3288, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  14. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March. [Downloadable!] (restricted)
    Other versions:
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Erik Theissen, 2003. "Organized Equity Markets in Germany," CFS Working Paper Series 2003/17, Center for Financial Studies. [Downloadable!]
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