Price Improvements in Financial Markets as a Screening Device

HEC Department of Finance Working Paper No. 716/2000

48 Pages Posted: 13 Mar 2001

See all articles by Thierry Foucault

Thierry Foucault

HEC Paris - Finance Department

Gabriel Desgranges

University of Cergy-Pontoise - THEMA

Date Written: December 2000

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).

Keywords: Market microstructure, price improvements, market design

JEL Classification: G10, G34

Suggested Citation

Foucault, Thierry and Desgranges, Gabriel, Price Improvements in Financial Markets as a Screening Device (December 2000). HEC Department of Finance Working Paper No. 716/2000. Available at SSRN: https://ssrn.com/abstract=263109 or http://dx.doi.org/10.2139/ssrn.263109

Thierry Foucault (Contact Author)

HEC Paris - Finance Department ( email )

1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France
(33)139679569 (Phone)
(33)139677085 (Fax)

HOME PAGE: http://thierryfoucault.com/

Gabriel Desgranges

University of Cergy-Pontoise - THEMA ( email )

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

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