A Simple OTC Pricing Model
This chapter, based entirely on Duffie, Gârleanu, and Pedersen (2005, 2007),1 presents a simple introduction to asset pricing in OTC markets. Investors search for opportunities to trade and bargain with counterparties, each counterparty being aware that failure to conduct a trade could lead to a costly new search for a counterparty. In equilibrium, whenever there is gain from trade, the opportunity to search for a new counterparty is dominated by trading at the equilibrium asset price. The asset price reflects the degree of search frictions.
Under conditions, illiquidity premia are higher when counterparties are harder to find, when sellers have less bargaining power, when the fraction of qualified owners is smaller, and when risk aversion, volatility, or hedging demand is larger. Supply shocks cause prices to jump, and then [recover] over time, with a pattern that depends on the degree of search frictions.
We show how the equilibrium bargaining powers of the counterparties are determined by search opportunities using the approach of Rubinstein and Wolinsky (1985).
Here, traders have the same information. The case of OTC trading with asymmetric information is treated in chapter 5.
This section introduces a simple model of asset pricing in an OTC market with risk-neutral investors. Later, we incorporate the effects of risk aversion.
1 Material in this chapter is adapted from Darrell Duffie, Nicolae Gârleanu, and Lasse Heje Pedersen, [Valuation in Over-the-Counter Markets,] Review of Financial Studies 20 (2007), 1865-1900, published by Oxford University Press.