Price Dispersion in OTC Markets: A New Measure of Liquidity

Rainer Jankowitsch, Amrut Nashikkar, Marti G. Subrahmanyam

Publication: Scientific journalJournal articleResearch

65 Citations (Scopus)

Abstract

In this paper, we model price dispersion effects in over-the-counter (OTC) markets to
show that, in the presence of inventory risk for dealers and search costs for investors, traded
prices may deviate from the expected market valuation of an asset. We interpret this devia-
tion as a liquidity effect and develop a new liquidity measure quantifying the price dispersion
in the context of the US corporate bond market. This market offers a unique opportunity tofstudy liquidity effects since, from October 2004 onwards, all OTC transactions in this marketfhave to be reported to a common database known as the Trade Reporting and CompliancefEngine (TRACE). Furthermore, market-wide average price quotes are available from MarkitGroup Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find
significant price dispersion effects that cannot be simply captured by bid-ask spreads. Wefshow that our new measure is indeed related to liquidity by regressing it on commonly-usedfliquidity proxies and find a strong relation between our proposed liquidity measure and bond
characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability
of end-of-day marks that traders use to value their positions. Our evidence suggests that the
price deviations from expected market valuations are significantly larger and more volatile
than previously assumed. Overall, the results presented here improve our understanding of
the drivers of liquidity and are important for many applications in OTC markets, in general. (authors' abstract)
Original languageEnglish
Pages (from-to)343-357
JournalJournal of Banking and Finance
Volume35
Issue number2
DOIs
Publication statusPublished - 21 Aug 2010

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