Reputation-Based Pricing and Price Improvements in Dealership Markets

52 Pages Posted: 11 Jun 2002

See all articles by Thierry Foucault

Thierry Foucault

HEC Paris - Finance Department

Gabriel Desgranges

University of Cergy-Pontoise - THEMA

Multiple version iconThere are 2 versions of this paper

Date Written: May 2002

Abstract

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.

Keywords: Market microstructure, reputation and implicit contracts, non-anonymous trading

JEL Classification: D82, G14, L14

Suggested Citation

Foucault, Thierry and Desgranges, Gabriel, Reputation-Based Pricing and Price Improvements in Dealership Markets (May 2002). Available at SSRN: https://ssrn.com/abstract=315683

Thierry Foucault

HEC Paris - Finance Department ( email )

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France
(33)139679569 (Phone)
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Gabriel Desgranges (Contact Author)

University of Cergy-Pontoise - THEMA ( email )

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F-95011 Cergy-Pontoise Cedex, 95011
France
+33 134 25 6135 (Phone)
+33 134 25 6233 (Fax)

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