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Price Improvements in Financial Markets as a Screening Device

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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).
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Dates and versions

hal-00598169 , version 1 (04-06-2011)

Identifiers

  • HAL Id : hal-00598169 , version 1

Cite

Thierry Foucault, Gabriel Desgranges. Price Improvements in Financial Markets as a Screening Device. 2011. ⟨hal-00598169⟩
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