Many assets are traded in decentralized markets intermediated by dealers. In these markets, search frictions lead to trading illiquidity. Moreover, terms of trade are negotiated between investors and dealers pursuant to strategic bargaining. Investors’ intrinsic types affect both their outside options and their bargaining powers. This paper proposes a search-based theory with strategic bargaining to study investors’ dynamic portfolio choice and equilibrium asset prices in intermediated markets. The model rationalizes well-documented empirical patterns, and generates additional predictions novel to the literature. A key prediction is that the relationship between asset prices and liquidity is non-monotonic. In the cross-section, the price-liquidity relationship is positive for sufficiently liquid assets but negative for highly illiquid assets. The average price-liquidity relation turns negative during severe crises. The model also predicts that transaction costs are higher for investor-sell trades than for investor-buy trades. The model predictions are supported by empirical evidence using corporate bond data.

Keywords: Intermediated Assets, OTC, Portfolio Choice, Liquidity, Bargaining