Reputation-Based Pricing and Price Improvements in Dealership Markets

52 Pages Posted: 23 Oct 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: January 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 her 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 his past trading profits with the trader requesting the improvement.

Note: Previously titled "Price Improvements in Financial Markets as a Screening Device"

Keywords: Market Microstructure, Price Improvements, Market Design, Anonymity

JEL Classification: F31, G15

Suggested Citation

Foucault, Thierry and Desgranges, Gabriel, Reputation-Based Pricing and Price Improvements in Dealership Markets (January 2002). AFA 2003 Washington, DC Meetings. Available at SSRN: https://ssrn.com/abstract=341720 or http://dx.doi.org/10.2139/ssrn.341720

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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