Dark Markets

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

Darrell Duffie
Copyright Date: 2012
Pages: 136
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  • Book Info
    Dark Markets
    Book Description:

    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 Marketsoffers 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.

    eISBN: 978-1-4008-4051-9
    Subjects: Finance

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-viii)
  3. List of Tables
    (pp. ix-x)
  4. List of Figures
    (pp. xi-xii)
  5. Preface
    (pp. xiii-xviii)
    Darrell Duffie
  6. CHAPTER 1 Over-the-Counter Markets
    (pp. 1-12)

    An over-the-counter (OTC) market does not use a centralized trading mechanism, such as an auction, specialist, or limit-order book, to aggregate bids and offers and to allocate trades. Instead, buyers and sellers negotiate terms privately, often in ignorance of the prices currently available from other potential counterparties and with limited knowledge of trades recently negotiated elsewhere in the market. OTC markets are thus said to be relatively opaque; investors are somewhat in the dark about the most attractive available terms and about whom to contact for attractive terms. Prices and allocations in OTC markets are to varying extents influenced by...

  7. CHAPTER 2 The Case of Federal Funds Lending
    (pp. 13-26)

    This chapter¹ shows how the intraday allocation and pricing of overnight loans of federal funds reflect the OTC interbank market in which these loans are traded. A would-be borrower or lender typically finds a counterparty institution by direct bilateral contact. Once in contact, say by telephone, the two counterparties to a potential trade negotiate terms that reflect their incentives for borrowing or lending, as well as the attractiveness of their respective options to forego a trade and to continue “shopping around.” This OTC pricing and allocation mechanism is quite distinct from that of most centralized markets, such as an electronic...

  8. CHAPTER 3 Search for Counterparties
    (pp. 27-41)

    This chapter introduces the modeling of search and random matching in large economies. The objective is to build intuition and techniques for later chapters. After some mathematical prerequisites, the notion of random matching is defined. The law of large numbers is then invoked to calculate the cross-sectional distribution of types of matches. This is extended to multiperiod search, first in discrete-time settings and then in continuous time. The optimal search intensity of a given agent, given the cross-sectional distribution of types in the population, is characterized with Bellman’s principle. We then briefly take up the issue of equilibrium search efforts....

  9. CHAPTER 4 A Simple OTC Pricing Model
    (pp. 42-62)

    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...

  10. CHAPTER 5 Information Percolation in OTC Markets
    (pp. 63-78)

    This chapter describes a simple model of the “percolation” of information of common interest through an OTC market with many agents. Agents encounter each other at random over time and reveal information to each other through bids and offers. We are particularly interested in the evolution over time of the cross-sectional distribution of the posterior probability assignments of the various agents. This chapter is based mainly on results from Duffie and Manso (2007), Duffie, Giroux, and Manso (2010), and Duffie, Malamud, and Manso (2010b).

    Hayek (1945) argued that markets allow information that is dispersed in a population to be revealed...

  11. APPENDIX A Foundations for Random Matching
    (pp. 79-83)
  12. APPENDIX B Counting Processes
    (pp. 84-86)
  13. Bibliography
    (pp. 87-92)
  14. Index
    (pp. 93-95)