Price Improvements in Financial Markets as a Screening Device
HEC Department of Finance Working Paper No. 716/2000
48 Pages Posted: 13 Mar 2001
Date Written: December 2000
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: Suggested Citation