Abstract

http://ssrn.com/abstract=1100704
 
 

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Price Dispersion in OTC Markets: A New Measure of Liquidity


Rainer Jankowitsch


WU (Vienna University of Economics and Business)

Amrut J. Nashikkar


New York University (NYU) - Department of Finance

Marti G. Subrahmanyam


New York University - Stern School of Business

April 2008

EFA 2008 Athens Meetings Paper

Abstract:     
In this paper, we model price dispersion effects in over-the-counter (OTC) markets to show that in the presence of inventory risk for dealers and search costs for investors, traded prices may deviate from the expected market valuation of an asset. We interpret this deviation as a liquidity effect and develop a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market. This market offers a unique opportunity to study liquidity effects since, from October 2004 onwards, all OTC transactions in this market have to be reported to a common database known as the Trade Reporting and Compliance Engine (TRACE). Furthermore, market-wide average price quotes are available from Markit Group Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find significant price dispersion effects that cannot be simply captured by bid-ask spreads. We show that our new measure is indeed related to liquidity by regressing it on commonly-used liquidity proxies and find a strong relation between our proposed liquidity measure and bond characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability of end-of-day marks that traders use to value their positions. Our evidence suggests that the price deviations are significantly larger and more volatile than previously assumed. Overall, the results presented here improve our understanding of the drivers of liquidity and are important for many applications in OTC markets, in general.

Number of Pages in PDF File: 36

Keywords: liquidity, corporate bonds, market microstructure, OTC markets

JEL Classification: G12

working papers series


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Date posted: March 4, 2008 ; Last revised: April 10, 2008

Suggested Citation

Jankowitsch, Rainer and Nashikkar, Amrut J. and Subrahmanyam, Marti G., Price Dispersion in OTC Markets: A New Measure of Liquidity (April 2008). EFA 2008 Athens Meetings Paper. Available at SSRN: http://ssrn.com/abstract=1100704 or http://dx.doi.org/10.2139/ssrn.1100704

Contact Information

Rainer Jankowitsch (Contact Author)
WU (Vienna University of Economics and Business) ( email )
Welthandelsplatz 1
Vienna, Vienna AT1020
Austria
+43 1 31 336 4340 (Phone)
+43 1 310 0580 (Fax)
Amrut J. Nashikkar
New York University (NYU) - Department of Finance ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
+1-212-998-0718 (Phone)
HOME PAGE: http://pages.stern.nyu.edu/~anashikk
Marti G. Subrahmanyam
New York University - Stern School of Business ( email )
Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)
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