Reputation-Based Pricing and Price Improvements in Dealership Markets
HEC Paris - Finance Department
University of Cergy-Pontoise - THEMA
CEPR Discussion Paper No. 3359
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 their 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 their past trading profits with the trader requesting the improvement.
Number of Pages in PDF File: 52
Keywords: Market microstructure, reputation and implicit contracts, non-anonymous trading
JEL Classification: D82, G14, L14working papers series
Date posted: June 11, 2002
© 2013 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo2 in 1.265 seconds