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Reputation-based pricing and price improvements in dealership markets

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  • DESGRANGES, Gabriel

    (Thema ; Université de Cergy)

  • FOUCAULT, Thierry

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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Bibliographic 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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  1. Madhavan, Ananth & Cheng, Minder, 1997. "In Search of Liquidity: Block Trades in the Upstairs and Downstairs Markets," Review of Financial Studies, Society for Financial Studies, vol. 10(1), pages 175-203.
  2. Dow, James, 1998. "Arbitrage, Hedging, and Financial Innovation," Review of Financial Studies, Society for Financial Studies, vol. 11(4), pages 739-55.
  3. Madhavan, Ananth, 1992. " Trading Mechanisms in Securities Markets," Journal of Finance, American Finance Association, vol. 47(2), pages 607-41, June.
  4. Kreps, David M. & Wilson, Robert, 1982. "Reputation and imperfect information," Journal of Economic Theory, Elsevier, vol. 27(2), pages 253-279, August.
  5. S. Baranzoni & P. Bianchi & L. Lambertini, 2000. "Market Structure," Working Papers 368, Dipartimento Scienze Economiche, Universita' di Bologna.
  6. Matthew Rhodes-Kropf, 2005. "Price Improvement in Dealership Markets," The Journal of Business, University of Chicago Press, vol. 78(4), pages 1137-1172, July.
  7. Seppi, Duane J, 1990. " Equilibrium Block Trading and Asymmetric Information," Journal of Finance, American Finance Association, vol. 45(1), pages 73-94, March.
  8. 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.
  9. 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.
  10. Madhavan, Ananth, 2000. "Market microstructure: A survey," Journal of Financial Markets, Elsevier, vol. 3(3), pages 205-258, August.
  11. Glosten, Lawrence R, 1989. "Insider Trading, Liquidity, and the Role of the Monopolist Specialist," The Journal of Business, University of Chicago Press, vol. 62(2), pages 211-35, April.
  12. Biais, Bruno & Glosten, Larry & Spatt, Chester S, 2002. "The Microstructure of Stock Markets," CEPR Discussion Papers 3288, C.E.P.R. Discussion Papers.
  13. 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, Society for Financial Studies, vol. 18(4), pages 1343-1368.
  14. Radner, Roy, 1985. "Repeated Principal-Agent Games with Discounting," Econometrica, Econometric Society, vol. 53(5), pages 1173-98, September.
  15. Lawrence R. Glosten & Paul R. Milgrom, 1983. "Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders," Discussion Papers 570, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  16. 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.
  17. Petersen, Mitchell A. & Fialkowski, David, 1994. "Posted versus effective spreads *1: Good prices or bad quotes?," Journal of Financial Economics, Elsevier, vol. 35(3), pages 269-292, June.
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