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Chicago Booth BUSF 35150 - Price Discovery in Illiquid Markets

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THE JOURNAL OF FINANCE•VOL. LXV, NO. 5•OCTOBER 2010Price Discovery in Illiquid Markets: Do FinancialAsset Prices Rise Faster Than They Fall?RICHARD C. GREEN, DAN LI, and NORMAN SCH¨URHOFF∗ABSTRACTWe study price discovery in municipal bonds, an important OTC market. As in mar-kets for consumer goods, prices “rise faster than they fall.” Round-trip profits todealers on retail trades increase in rising markets but do not decrease in fallingmarkets. Further, effective half-spreads increase or decrease more when movementsin fundamentals favor dealers. Yield spreads relative to Treasuries also adjust withasymmetric speed in rising and falling markets. Finally, intraday price dispersion isasymmetric in rising and falling markets, as consumer search theory would predict.IN A WIDE VARIETY OF CONSUMER MARKETS, prices for retail goods rise fasterthan they fall.1This asymmetric price adjustment, referred to as “rockets andfeathers,” is generally understood by economists to be inconsistent with perfectcompetition between sellers. Sellers appear to exploit local market power dueto the search frictions that their customers face.We document asymmetric price adjustment in a major over-the-counter(OTC) financial market using a comprehensive sample of all trades in mu-nicipal bonds over a 5-year period. We provide evidence that the asymmetricprice adjustment is associated with opportunistic timing by the broker-dealerswho intermediate trades in the market. Movements in fundamentals that in-crease spreads earned by broker-dealers are reflected quickly in prices, whileprices respond more slowly to changes that reduce their spreads. Further, theasymmetries are more pronounced in states where tax treatment of the bondswould induce market segmentation. We also document asymmetries in within-day price dispersion, as implied by theoretical models of rockets-and-feathersprice adjustments based on costly consumer search and learning.∗Richard C. Green is with the Tepper School of Business at Carnegie Mellon University, DanLi is with the Board of Governors of the Federal Reserve System, and Norman Sch¨urhoff is withthe Faculty of Business and Economics at University of Lausanne, Swiss Finance Institute, andCEPR. The third author acknowledges research support from the Swiss Finance Institute and fromNCCR FINRISK of the Swiss National Science Foundation. Seminar participants at Arizona State,Carnegie Mellon, Columbia, George Mason, Lausanne, Miami, Oklahoma, Oxford, and Whartonprovided helpful comments and guidance. We greatly appreciate the feedback from our discussantsLarry Harris, Adam Kolasinski, and Bruce Lehmann and conference participants at the AFA 2009,EFA 2008, and 2ndWorkshop on Financial Market Quality. An anonymous referee and AssociateEditor, along with the Editor, Campbell Harvey, have done much to improve the paper. We thankTal Heppenstall, J.C. Stilley, and Jim Konieczny of University of Pittsburgh Medical Center forconversations that alerted us to the problems studied in this paper.1See Peltzman (2000) and the many references therein.16691670 The Journal of FinanceR In the municipal bond market, unlike the markets for most consumer goods,dealers trade with retail customers as both buyers and sellers. We show thaton the ask side of the market, where dealers are selling, prices rise faster thanthey fall. On the bid side, where dealers are buying, prices fall faster thanthey rise. Since dealers in seasoned municipals tend to intermediate betweenlarge, better informed sellers, on the one hand, and small investors who buyand hold, on the other, measures of average prices such as the midpoint inheritthe asymmetry on the ask side; that is, they rise faster than they fall, just asprices in consumer markets do. On average dealers are “buying wholesale” and“selling retail,” so the asymmetric movement in prices benefits them.Our findings are of obvious importance to investors, issuers, and regulatorsinvolved with the municipal bond market, which represents $1.7 trillion of out-standing bonds. The implications of these findings reach beyond the immediatesetting, however, for at least three reasons.First, many securities trade in opaque, decentralized OTC markets. Regula-tors and investors often complain that the lack of price transparency in thesemarkets interferes with price discovery, discourages trade, increases costs oftrade, and creates local market power for financial intermediaries. The direc-tion of causality, however, is ambiguous as trading venue, volume of trade, andcosts of trade are jointly endogenous outcomes. For instance, the securities inquestion may trade in decentralized markets precisely because investors rarelywish to trade them. Dealers might therefore earn high profits arranging trades,even under perfect competition, if the costs of identifying and matching coun-terparties with coincident needs are high. Our findings of asymmetric priceadjustment are instructive because it is difficult to imagine any more primitivecondition that would lead prices to rise faster than they fall in a competitivemarketplace. The only explanations of such behavior offered in the economicsliterature involve search costs for consumers and imperfect competition be-tween sellers.Second, our research suggests that the market is failing at one of its fun-damental functions, efficient price discovery. Past research on OTC financialmarkets shows that the costs of trade are high for retail investors, and thatthese higher costs appear to be due to search costs and a lack of price trans-parency.2An unanswered question is how these costs affect price discovery—the efficiency with which prices reflect information. Even if trade is costly andinfrequent, the transactions that do occur can still be at prices that efficientlyincorporate public information. If retail investors face high costs of trade, fi-nancial intermediaries such as mutual funds will arise to limit these costs.Thus, investors who are unsophisticated shoppers for municipal or corporatebonds are only hurting themselves. Financial market prices, however, haveconsequences that reach beyond the investors and intermediaries directly in-volved in a given trade. Prices serve as signals for resource allocation more2See, for example, Harris and Piwowar (2006), Bessembinder, Maxwell, and Venkataraman(2006), Goldstein, Hotchkiss, and Sirri (2007), Edwards, Harris, and Piwowar (2007), and Green,Hollifield, and Sch¨urhoff (2007a).Price


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