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Price Discovery in Markets with Multiple Dealers

  • Rafael Romeu
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    Dealers learn about asset values as they set prices and absorb informed order flow. These flows cause inventory imbalances. This study models price setting in markets such as foreign exchange, U.S. treasury bonds, European sovereign bonds, and the London Stock Exchange, where market makers have multiple instruments to smooth inventory imbalances and update priors about asset values. Estimating a dealer pricing model with multiple instruments for inventory control and information-gathering yields support for what at times have been elusive inventory and asymmetric information effects. The model presented yields direct measures of the structural-liquidity cost parameters faced by market makers, akin to Kyle's Lambda. For example, the estimates presented suggest that a $10 million incoming purchase pushes price up by roughly one basis point, and dealers expect to immediately lay off one-third of every incoming order. Compared with estimates of price setting in single dealer markets, price shading is found to have a smaller role in inventory management and information effects are shown to be stronger. Hence, estimating traditional microstructure models (based on only one market maker per asset) on data from asset markets where market makers have multiple instruments misses information from sources other than incoming order flows, and overemphasizes price shading in managing inventories.

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    Article provided by Palgrave Macmillan in its journal IMF Staff Papers.

    Volume (Year): 57 (2010)
    Issue (Month): 2 (June)
    Pages: 450-483

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    Handle: RePEc:pal:imfstp:v:57:y:2010:i:2:p:450-483
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