You are invited to an IEOR Monday Seminar:

Over-the-Counter Search Frictions:

A Case Study of the Federal Funds Market

Professor Darell Duffie

Stanford University, Graduate School of Business

Abstract

This paper shows how the intra-day allocation and pricing of overnight loans of federal funds reflect the decentralized inter-bank 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 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 anonymously exposed to every other order with a centralized order-crossing algorithm.

Among other results, we show how the likelihood that some bank I  borrows from some other bank j during a particular minute t of a business day depends on the prior trading relationship between these two banks, the extents to which their balances at the beginning of minute t are above or below their normal respective balances for that time of day, their overall levels of trading activities, the amount of time left until their end-of-day balances are monitored for reserve-requirement purposes, and the volatility of the federal funds rate in the trailing 30 minutes. We also show how the interest rate negotiated in a particular trade depends on some of these incentive-related variables and on a measure of the credit quality of the borrowing _financial institution. While there is a significant body of research on the micro-structure of specialist and limit-order-book markets, most OTC markets do not have comprehensive transactions-level data available for analysis. The federal funds market is a rare exception.

We go beyond a previous study by Furnfine (1999) of the microstructure of the federal funds market by modeling 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 abilities 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 market theory.

Biographical Sketch:

Darrell Duffie is the Dean Witter Distinguished Professor of Finance at The Graduate School of Business, Stanford University, where he has been a member of the finance faculty since receiving his Ph.D. at Stanford in 1984. Among other books, Duffie is the author of Dynamic Asset Pricing Theory (Princeton University Press, third edition 2001) and a co-author with Ken Singleton of Credit Risk (Princeton University Press, 2004). His recent research focuses on asset pricing, credit risk, fixed-income securities, and over-the-counter markets. Duffie is a past Director of The Board of The American Finance Association, a Fellow of the Econometric Society, a Research Associate of the National Bureau of Economic Research, a member of Moody's Academic Research Committee, and the 2003 IAFE/Sunguard Financial Engineer of the Year.

3108 Etcheverry

Monday, 27 November 2006

3:30PM-4:30PM

Come early! Refreshments will be served at 3:00PM.