Valuation in over-the-counter markets

We provide the impact on asset prices of search-and-bargaining frictions in over-the-counter markets. Under certain conditions, illiquidity discounts are higher when counterparties are harder to find, when sellers have less bargaining power, when the fraction of qualified owners is smaller, or when risk aversion, volatility, or hedging demand is larger. Supply shocks cause prices to jump, and then ‘‘recover’ ’ over time, with a time signature that is exaggerated by search frictions: The price jump is larger and the recovery is slower in less liquid markets. We discuss a variety of empirical implications. (JEL G1, G12, G14, D83, D4, D52) Many assets, such as mortgage-backed securities, corporate bonds, government bonds, US federal funds, emerging-market debt, bank loans, swaps and many other derivatives, private equity, and real estate, are traded in over-the-counter (OTC) markets. Traders in these markets search for counterparties, incurring opportunity or other costs. When counterparties meet, their bilateral relationship is strategic; prices are set through a bargaining process that reflects each investor’s alternatives t