DP13126 Frictional intermediation in over-the-counter markets
We extend Duffie, Garleanu, and Pedersen's (2005) search-theoretic model of over-the-counter asset markets, allowing for a decentralized inter-dealer market with arbitrary heterogeneity in dealers' valuations or inventory costs. We develop a solution technique that makes the model fully tractable and allows us to derive, in closed form, theoretical formulas for key statistics analyzed in empirical studies of the intermediation process in OTC market. A calibration to the market for municipal securities reveals that the model can generate trading patterns and prices that are quantitatively consistent with the data. We use the calibrated model to compare the gains from trade that are realized in this frictional market with those from a hypothetical, frictionless environment, and to distinguish between the quantitative implications of various types of heterogeneity across dealers.
