Valuation in Over-the-Counter Markets

We provide the impact on asset prices of search-and-bargaining frictions in over-the-counter markets. Under natural conditions, prices are lower and illiquidity discounts higher when counterparties are harder to find, when sellers have less bargaining power, when the fraction of qualified owners is smaller, or when risk aversion, volatility, or hedging demand are larger. If agents face risk limits, then higher volatility leads to greater difficulty locating unconstrained buyers, resulting in lower prices. Information can fail to be revealed through trading when search is difficult. We discuss a variety of financial applications and testable implications. This paper includes work previously distributed under the title “Valuation in Dynamic Bargaining Markets.” We are grateful for conversations with Yakov Amihud, Helmut Bester, Joseph Langsam, Richard Lyons, Tano Santos, and Jeff Zwiebel, and to participants at the NBER Asset Pricing Meeting, the Cowles Foundation Incomplete Markets and Strategic Games Conference, Hitotsubashi University, The London School of Economics, The University of Pennsylania, the Western Finance Association conference, the CEPR meeting at Gerzensee, University College London, The University of California, Berkeley, Université Libre de Bruxelles, Tel Aviv University, Yale University, and Universitat Autonoma de Barcelona. We also thank Gustavo Manso for research assistance. Graduate School of Business, Stanford University, Stanford, CA 94305-5015, email: [email protected]. Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104-6367, email [email protected]. Stern School of Business, New York University, 44 West Fourth Street, Suite 9-190, New York, NY 10012-1126, email: [email protected]. Many assets, such as mortgage-backed securities, corporate bonds, emergingmarket debt, bank loans, over-the-counter (OTC) derivatives, private equity, and real estate, are traded in OTC markets. Traders in OTC markets must search for counterparties, incurring opportunity or other costs. When two counterparties meet, their bilateral relationship is strategic; prices are set through a bargaining process that reflects each investor’s alternatives to immediate trade. We provide a theory and applications of dynamic asset pricing in OTC markets, one that explicitly treats search and bargaining. We show how the explicitly calculated equilibrium allocations and prices depend on investors’ search abilities, bargaining powers, risk limits, and risk aversion, and discuss a variety of financial applications and testable implications. Under natural conditions, illiquidity discounts are lower, and prices are higher, if investors can find each other more easily, if sellers have more bargaining power, if the fraction of qualified owners is greater, if volatility is lower, or if risk aversion is lower. If agents face risk limits, then higher volatility leads to greater difficulty locating unconstrained buyers, resulting in higher illiquidity discounts and lower prices. Finally, information can fail to be revealed through trade when search is difficult. We first model the pricing of a consol bond traded by risk-neutral agents, a special case of the model by Duffie, Gârleanu, and Pedersen (2003). Investors contact one another randomly at some mean rate λ, a parameter reflecting search ability. When two agents meet, they bargain over the terms of trade based on endogenously determined outside options. Gains from trade arise from heterogeneous costs or benefits of holding assets. We then extend this model to OTC markets with risky securities. This allows us to incorporate the effects of risk aversion, risk limits, and private information. In our OTC market model, a risk-averse asset owner searches for a potential buyer when the asset ceases to be a relatively good hedge of his endowment. We show how asset prices are affected by search frictions and demonstrate how they could magnify the effective risk premium due to incomplete risk sharing, beyond that of a liquid but incomplete-markets setting such as Constantinides and Duffie (1996). Our result complements the literature that studies the price effect of exogenously specified trading cost (Amihud and Mendelson (1986), Constantinides (1986), Vayanos (1998), and Huang (2003)) by endogenizing the trading cost in the context of OTC markets. Krainer and LeRoy (2002) study