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Financial Intermediation and the Costs of Trading in an Opaque Market

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  • Richard C. Green

    (Tepper School of Business, Carnegie Mellon University)

  • Burton Hollifield

    (Tepper School of Business, Carnegie Mellon University)

  • Norman Schürhoff

    (HEC, University of Lausanne and FAME)

Abstract

Municipal bonds trade in opaque, decentralized broker-dealer markets in which price information is costly to gather. Whether dealers in such a market operate competitively is an empirical issue, but a difficult one to study. Data in such markets is generally not centrally recorded. We analyze a comprehensive database of all trades between broker-dealers in municipal bonds and their customers. The data is only released to the public with a substancial lag, and thus the market was relativela opaque to the traders themselves during our sample period. We find that dealers earn lower average markups on larger trades, even though larger trades lead the dealers to bear more risk of losses. We formulate and estimate a simple structural bargaining model that allows us to estimate mesures of dealer bargaining power and it relate it to the characteristics of the trades. The results suggest dealers exercise substancial market power. Our mesures of market power decrease in trade size and increase in variables that indicate the complexity of the trade for the dealer.

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Bibliographic Info

Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp130.

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Date of creation: Feb 2005
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Handle: RePEc:fam:rpseri:rp130

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Keywords: Municipal Bonds; Fixed Income Dealer; Transaction Costs; Liquidity; Transparency; Market Power;

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  1. Kumbhakar,Subal C. & Lovell,C. A. Knox, 2003. "Stochastic Frontier Analysis," Cambridge Books, Cambridge University Press, number 9780521666633, April.
  2. Aigner, Dennis & Lovell, C. A. Knox & Schmidt, Peter, 1977. "Formulation and estimation of stochastic frontier production function models," Journal of Econometrics, Elsevier, vol. 6(1), pages 21-37, July.
  3. Green, Richard C, 1993. "A Simple Model of the Taxable and Tax-Exempt Yield Curves," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 233-64.
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