Strategic Bargaining and Portfolio Choice in Intermediated Markets

Jessica Li, Finance PhD student

Many assets are traded in decentralized markets intermediated by dealers. In these markets, terms of trade are negotiated between trading parties pursuant to strategic bargaining. Investors’ bargaining positions weaken when they experience liquidity shocks. In this paper, I propose a search-based theory with strategic bargaining to study investors’ dynamic portfolio choice and equilibrium asset prices in intermediated markets. Investors hold less extreme positions in illiquid assets, leading to lower trading volumes in these assets. Interestingly, the relationship between asset liquidity and prices is non-monotonic. More liquid assets may not command positive liquidity premia and trade at higher prices. In the cross-section, there is a liquidity threshold such that assets above the threshold (i.e., relatively liquid assets) exhibit positive liquidity premia, while assets below the threshold (i.e., highly illiquid assets) exhibit negative liquidity premia. Furthermore, negative liquidity premia are more prevalent during crises. The model implications are consistent with empirical evidence using corporate bond transaction data