Dark Markets: Asset Pricing and Information Transmission in over-the-Counter Markets

Dark Markets: Asset Pricing and Information Transmission in over-the-Counter Markets

Dark Markets: Asset Pricing and Information Transmission in over-the-Counter Markets

Dark Markets: Asset Pricing and Information Transmission in over-the-Counter Markets

Synopsis

Over-the-counter (OTC) markets for derivatives, collateralized debt obligations, and repurchase agreements played a significant role in the global financial crisis. Rather than being traded through a centralized institution such as a stock exchange, OTC trades are negotiated privately between market participants who may be unaware of prices that are currently available elsewhere in the market. In these relatively opaque markets, investors can be in the dark about the most attractive available terms and who might be offering them. This opaqueness exacerbated the financial crisis, as regulators and market participants were unable to quickly assess the risks and pricing of these instruments.



Dark Markets offers a concise introduction to OTC markets by explaining key conceptual issues and modeling techniques, and by providing readers with a foundation for more advanced subjects in this field. Darrell Duffie covers the basic methods for modeling search and random matching in economies with many agents. He gives an overview of asset pricing in OTC markets with symmetric and asymmetric information, showing how information percolates through these markets as investors encounter each other over time. This book also features appendixes containing methodologies supporting the more theory-oriented of the chapters, making this the most self-contained introduction to OTC markets available.

Excerpt

This research monograph addresses the behavior of over-the-counter (OTC) markets. Rather than trading through a centralized mechanism such as an auction, specialist, or broadly accessible limit-order book, participants in an otc market negotiate terms privately with other market participants, often pairwise. otc investors, other than major dealers, may be largely unaware of prices that are currently available elsewhere in the market, or of recent transactions prices. in this sense, otc markets are relatively opaque; investors are somewhat in the dark about the most attractive available terms and about who might offer them. We will focus attention on how prices, asset allocations, and information transmission in otc markets are influenced by opaqueness.

The financial crisis of 2007–2009 brought significant concerns and regulatory action regarding the role of otc markets, particularly from the viewpoint of financial instability. otc markets for derivatives, collateralized debt obligations, and repurchase agreements played particularly important roles in the crisis and in subsequent legislation. the modeling of otc markets, however, is still undeveloped in comparison to the available research on central market mechanisms.

My objective is to provide a brief introduction to otc markets, including some of the key conceptual issues and modeling techniques. I hope to serve the interests of relevant sets of academics, investors, and regulators. Those reading beyond chapter 2 are assumed to have a graduate-level knowledge of probability theory.

Chapter 1 introduces the institutional setting of otc markets and raises some of the key conceptual issues associated with market opaqueness. Chapter 2, from joint work with Adam Ashcraft, is a case example: the otc market for overnight loans of federal funds, the [cash] of the U.S. banking system. Adam and I are grateful for support and data from the Federal Reserve Bank of New York and for conversations with Jamie McAndrews, Craig Furfine, and anonymous federal funds traders. We also benefited from . . .

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