Liquidity Dynamics in RFQ Markets and Impact on Pricing

TL;DR

This paper develops a new framework for valuing illiquid OTC securities using micro-price and fair transfer price concepts, incorporating liquidity dynamics modeled by bidimensional Markov processes.

Contribution

It extends the micro-price concept to RFQ markets and introduces the Fair Transfer Price for more accurate valuation under liquidity constraints.

Findings

Micro-price can be adapted to RFQ OTC markets.

Fair Transfer Price provides fair valuation in illiquid conditions.

Liquidity dynamics are effectively modeled with Markov-modulated Poisson processes.

Abstract

To assign a value to a portfolio, it is common to use Mark-to-Market prices. However, how should one proceed when the securities are illiquid? When transaction prices are scarce, how can one use all the available real-time information? In this article, we address these questions for over-the-counter (OTC) markets based on requests for quotes (RFQs). We extend the concept of micro-price, which was recently introduced for assets exchanged through limit order books in the market microstructure literature, and incorporate ideas from the recent literature on OTC market making. To account for liquidity imbalances in RFQ markets, we use an approach based on bidimensional Markov-modulated Poisson processes. Beyond extending the concept of micro-price to RFQ markets, we introduce the new concept of Fair Transfer Price. Our concepts of price can be used to value securities fairly, even when the market is relatively illiquid and/or tends to be one-sided.