New Findings in the Market Microstructure of Over-the-counter Markets a Dissertation in Financial Economics Submitted to the Tepper School of Business Carnegie Mellon University in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy

This dissertation studies the market microstructure of over-the-counter markets. All three chapters are based on the municipal (tax-exempt) bond market. However, the implications on price formation, price discovery and dealer’s market power can be generalized into the other OTC markets such as corporate bond and derivatives markets as well. In the first chapter “Price Clustering and Dealer’s Market Power”, I find that prices, yields and markups in the municipal bond market are very clustered at rounded numbers. The level of rounding is higher in trades between dealers and customers than in interdealer trades. Rounding is also more prominent in trades of retail sizes. I attribute the heterogeneous rounding observations to the dealers’ market power. Such discriminative practice is described in a sequential bargaining model, and the prediction of the model is statistically verified in the data. Dealer’s profit is indeed monotonically increasing with the pricing grid, and dealers are indeed rounding prices asymmetrically. They round price up when they are selling, round price down when they are buying. Thus, unlike the findings in more competitive financial markets, where the benefits of rounding is shared by both sides of the trades, rounding solely benefits the dealers and constitutes additional transaction cost to investors in the tax-exempt market. In the second chapter “Agreeing on a Higher Price — Investor Rationality Test in TaxExempt Bond Market”, I find that buyers in the tax-exempt bond market are bounded rational. They do not fully consider that tax consequences of their trades when purchasing