[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.]

This paper shows how the intraday allocation and pricing of overnight loans of federal funds reflect the decentralized interbank market in which these loans are traded. A would-be bor-rower or lender typically finds a counterparty institution by direct bilateral contact. Once in contact, the two counterparties to a potential trade negotiate terms that reflect their incentives for borrowing or lending, as well as the attrac-tiveness of their respective options to forego a trade and to continue “shopping around. ” This over-the-counter (OTC) pricing and allocation mechanism is quite distinct from that of most centralized markets, such as an electronic limit order book market in which every order is anony-mously exposed to every other order with a cen-tralized order-crossing algorithm. While there is a significant body of research on the microstructure of specialist and limit order book markets, most OTC markets do not have comprehensive transaction-level data available for analysis. The federal funds mar-ket is a rare exception. We go beyond a previ-ous study of the microstructure of the federal funds market (Craig H. Furfine 1999) by model-ing how the likelihood of matching a particular borrower with a particular lender, as well as the interest rate that they negotiate, depend on their respective incentives to add or reduce balances and their ability to conduct further trading with other counterparties (proxied by the level of their past trading volumes). Our results are consistent with the thrust of search-based OTC financial

We provide maximum likelihood estimators of term structures of conditional probabilities of corporate default, incorporating the dynamics of firm-specific and macroeconomic covariates. For US Industrial firms, based on over 390,000 firm-months of data spanning 1980 to 2004, the term structure of conditional future default probabilities depends on a firm's distance to default (a volatility-adjusted measure of leverage), on the firm's trailing stock return, on trailing S&P 500 returns, and on US interest rates. The out-of-sample predictive performance of the model is an improvement over that of other available models.

We introduce a simple model of the “percolation ” of information of common interest through a large market, as agents encounter each other over time and reveal information to each other, some of which they may have received earlier from other agents. We are particularly interested in the evolution over time of the cross-sectional distribution in the population of the posterior probability assignments of the various agents. We provide a market example based on privately held auctions, and show how the rate of convergence of the cross-sectional distribution of information is determined by the frequency of auctions and by the number of agents bidding at each auction. Our results contribute to the literature on information transmission in markets. Hayek (1945) argues that markets allow information that is dispersed in a population to be revealed through prices. Grossman’s (1981) notion of a rational-expectations equilibrium formalizes this idea in a centralized market. A number of important markets, however, are decentralized. These include over-the-counter markets and private-auction markets. Wolinsky (1990) and Blouin and Serrano (2002) study information transmission in decentralized markets. 2 In contrast to these two papers, equilibrium behavior in our market example leads to full revelation of information

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.

ABSTRACT We test the doubly stochastic assumption under which firms' default times are correlated only as implied by the correlation of factors determining their default intensities. Using data on U.S. corporations from 1979 to 2004, this assumption is violated in the presence of contagion or “frailty” (unobservable explanatory variables that are correlated across firms). Our tests do not depend on the time‐series properties of default intensities. The data do not support the joint hypothesis of well‐specified default intensities and the doubly stochastic assumption. We find some evidence of default clustering exceeding that implied by the doubly stochastic model with the given intensities.