Firstly, let us note that the equilibrium bidding schedule is flatter in the limit order market (8.15) than in the uniform price market (8.17); this is because with price discrimination, competition for liquidity provision intensifies. Figure 8.1 plots the bid schedule under the discriminatory (8.16) and the uniform pricing rules (8.18) for different numbers of dealers: competition modifies only the slope of the uniform pricing schedule, but for the discriminatory schedule it also changes the intercept.
As mentioned, the model in Viswanathan andWang (2002) does not allow for asymmetric information among market participants. Biais, Martimort and Rochet (2000) introduce adverse selection in a model with the discriminatory pricing rule and show how imperfect competition among dealers within an LOB can be modelled as a game with multiple principals, where each dealer (principal) chooses his optimal trading strategy under the participation and incentive constraints of the investor (agent).
As a consequence each of the mentioned types of bank capital represents its own risk class. Investors clearly have to be compensated to carry the additional risks compared with senior bank bonds. Figure 4.3 shows that on average the spread differentials between senior bonds and Lower Tier 2, Lower Tier 2 and Upper Tier 2, and Upper Tier 2 and Tier 1 tend to be roughly equal. But one should note that spread volatility also increases significantly when moving to more subordinated types of bank debt. Again, this can be explained by the Merton model. Since Tier 1 and Upper Tier 2 bonds are designed to absorb losses before holders of senior bonds and Lower Tier 2 suffer a loss, the strike price of their embedded short put option is closer at the money than that of senior and Lower Tier 2 bonds. Hence, in absolute terms the delta of the short put is higher, causing larger changes of the value of the option and consequently spreads, when fundamentals change.
BBB-rated corporate bonds obviously have a very high correlation to fluctuations of credit spreads in general. Although they made up on average only 25 percent of the Euro investment grade market, the influence of lower rated bonds on market spreads is substantial. Higher quality bonds, on the other hand, exhibit lower correlations to market spread changes. One reason is that their impact on the market direction is less pronounced because they are less volatile. But the second reason is probably more important. Euro corporate bonds are typically valued against swaps, that is the spread versus government bonds consists of two components: the swap spread and the spread over swaps. As a consequence changes of swap spreads have an influence on the spread of a corporate bond versus duration-matched treasuries. The higher the credit quality and the lower the spread of an issuer, the higher is the fraction of the benchmark spread that is due to the swap spread.
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