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Price Improvements in Financial Markets as a Screening Device

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  • G. Desgranges
  • T. Foucault

Abstract

In many security markets, market-makers offer to trade at a discount relative to their posted bid and ask quotes. In this article we provide an explanation to this phenomenon. We show that market-makers can mitigate informational asymmetries by selectively offering price improvements to their regular clients. We study a specific type of pricing strategy which consists (a) in offering price improvements to investors who have not repeatedly inflicted trading losses to the market-maker uses this pricing strategy, there are equilibria in which his clients optimally choose not to contact him when they have private information. These equilibria Pareto-dominate those which are obtained when the market-marker does not or can not make his quotes contingent on his clients' trading histories. Our Model predicts that (1) market-makers should grant price improvements to their regular clients but that (2) these improvements should be temporarily suspended after sequences of purchases (sales) followed by price increases (decreases).
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Suggested Citation

  • G. Desgranges & T. Foucault, 2001. "Price Improvements in Financial Markets as a Screening Device," THEMA Working Papers 2001-06, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
    • Handle: RePEc:ema:worpap:2001-06
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    File URL: http://www.u-cergy.fr/IMG/documents//2001-06.Desgranges.pdf
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    References listed on IDEAS

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    1. Seppi, Duane J, 1990. "Equilibrium Block Trading and Asymmetric Information," Journal of Finance, American Finance Association, vol. 45(1), pages 73-94, March.
    2. 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.
    3. Matthew Rhodes-Kropf, 2005. "Price Improvement in Dealership Markets," The Journal of Business, University of Chicago Press, vol. 78(4), pages 1137-1172, July.
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    Cited by:

    1. Erik Theissen, 2003. "Trader Anonymity, Price Formation and Liquidity," Review of Finance, European Finance Association, vol. 7(1), pages 1-26.

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