The Structure and Performance The Structure and Performance of Securities Marketsof Securities Markets

Chapter 6Chapter 6

Nature and Function Nature and Function of Securities Marketsof Securities Markets

All markets bring sellers and buyers togetherAll markets bring sellers and buyers togetherPrice balances supply and demand for the Price balances supply and demand for the securities by securities by allall potential market participants potential market participantsKey role of markets is to provide information to Key role of markets is to provide information to buyers/sellersbuyers/sellersMarkets reduce transaction costsMarkets reduce transaction costs– Buyers and sellers may be unaware of each otherBuyers and sellers may be unaware of each other– Different locationsDifferent locations– Different timesDifferent times

Primary vs. Secondary MarketsPrimary vs. Secondary Markets

Primary MarketsPrimary Markets– Deal in newly issued securitiesDeal in newly issued securities

Secondary MarketsSecondary Markets– Deal in existing securitiesDeal in existing securities

Primary MarketsPrimary Markets

Investment BanksInvestment BanksUnderwritingsUnderwritings– Underwriting spreadsUnderwriting spreads

Tombstone AdsTombstone AdsTrading in this market is not in a physical Trading in this market is not in a physical market, but electronically or personally market, but electronically or personally between the investment bankers and between the investment bankers and ultimate investors—usually large ultimate investors—usually large institutional investorsinstitutional investors

Theglobe.comTheglobe.com

Dallas Morning NewsDallas Morning News– Monday, April 19, 1999Monday, April 19, 1999

From Start to Finish:From Start to Finish:– The seven steps of the IPO process, and how The seven steps of the IPO process, and how

theglobe.com specifically went from “bake-off” theglobe.com specifically went from “bake-off” to completion.to completion.

Initial Public OfferingsInitial Public Offerings

www.ipocentral.comwww.ipocentral.com

Secondary MarketsSecondary Markets

Three main types:Three main types:– Auction MarketAuction Market– Brokered MarketBrokered Market– Dealer MarketDealer Market

Market orders vs. Limit ordersMarket orders vs. Limit orders

Auction MarketAuction Market

Buyers and sellers confront each other directly Buyers and sellers confront each other directly to set the priceto set the priceEither a single trade between all parties at a Either a single trade between all parties at a single price or a series of trades at different single price or a series of trades at different pricespricesParticular rules of the auction determine exactly Particular rules of the auction determine exactly how buyers and sellers are matched up.how buyers and sellers are matched up.All buy/sell orders are centralized so highest All buy/sell orders are centralized so highest bidders and lowest offers are exposed to each bidders and lowest offers are exposed to each otherother

Auction MarketAuction Market

PostsPosts—Specific locations where auctions —Specific locations where auctions for individual securities take placefor individual securities take place

SpecialistsSpecialists—Individual designated by the —Individual designated by the exchange to represent buy/sell orders exchange to represent buy/sell orders tendered by customerstendered by customers

NYSENYSE

AMEXAMEX

Brokered MarketBrokered Market

Buyers/sellers employ services of a broker to Buyers/sellers employ services of a broker to search for information about the “other side” of search for information about the “other side” of the tradethe tradeBroker’s role is to provide informationBroker’s role is to provide informationBrokers earn a commissionBrokers earn a commissionReal estate brokersReal estate brokers—provide information for —provide information for buyers/sellers of homesbuyers/sellers of homesMunicipal bonds are traded primarily in a Municipal bonds are traded primarily in a brokered marketbrokered market

Dealer MarketDealer Market

Security dealers sell/buy for their own accountSecurity dealers sell/buy for their own accountHelp to stabilize the marketHelp to stabilize the marketCommit own capital in process of bringing Commit own capital in process of bringing sellers and buyers togethersellers and buyers togetherExpect to earn a profit by “buying low and selling Expect to earn a profit by “buying low and selling high”high”Take a risk on a change of price in the securities Take a risk on a change of price in the securities they own they own

Dealer MarketsDealer Markets

Most securities trade in dealer marketsMost securities trade in dealer markets

Over-the counter (OTC)Over-the counter (OTC)– Network of dealers linked together by Network of dealers linked together by

telephone or computerstelephone or computers– Most trades take place in a partially Most trades take place in a partially

automated electronic stock market called automated electronic stock market called NASDAQNASDAQ—National Association of Security —National Association of Security Dealers Automated Quotation SystemDealers Automated Quotation System

Dealer MarketsDealer Markets

Organizational structure of a dealer market Organizational structure of a dealer market and technological information keep and technological information keep transaction prices as close to true transaction prices as close to true equilibrium as is economically feasibleequilibrium as is economically feasible

Good Good marketabilitymarketability of a security implies it of a security implies it can be sold, liquidated, and turned into can be sold, liquidated, and turned into cash very quickly without a collapse in cash very quickly without a collapse in priceprice

Efficiency of Secondary Efficiency of Secondary Market Trading Market Trading

Efficient markets result in a transaction price Efficient markets result in a transaction price close to true equilibrium price—close to true equilibrium price—highly liquidhighly liquidLow transaction costs-timely informationLow transaction costs-timely informationWalrasian auctionWalrasian auction– Auctioneer announces the price and asks Auctioneer announces the price and asks

buyers/sellers to submit quantities they want to buy or buyers/sellers to submit quantities they want to buy or sellsell

– If not equal, auctioneer raises or lowers price until the If not equal, auctioneer raises or lowers price until the market clearsmarket clears—quantity demanded is equal to —quantity demanded is equal to quantity suppliedquantity supplied

– Exchange occurs at single equilibrium priceExchange occurs at single equilibrium price

Efficiency of Secondary Efficiency of Secondary Market TradingMarket Trading

Financial markets operate differently with Financial markets operate differently with transactions occurring continuously transactions occurring continuously throughout the day at different pricesthroughout the day at different prices

Dealers (Dealers (market makersmarket makers) quote a bid ) quote a bid price at which they will buy (seller’s supply price at which they will buy (seller’s supply curve) and an offer price at which they will curve) and an offer price at which they will sell (buyer’s demand curve)sell (buyer’s demand curve)

Efficiency of Secondary Efficiency of Secondary Market TradingMarket Trading

Dealer’s objective is to sell inventory that Dealer’s objective is to sell inventory that has been purchased before the equilibrium has been purchased before the equilibrium price has an opportunity to changeprice has an opportunity to change

Since buyers/sellers are concerned that Since buyers/sellers are concerned that equilibrium price might change before the equilibrium price might change before the auction occurs, they may chose to transact auction occurs, they may chose to transact at dealer’s bid and offer price.at dealer’s bid and offer price.

Measure of LiquidityMeasure of Liquidity

Spread between bid and asked pricesSpread between bid and asked prices– Bid PriceBid Price—What dealer is willing to pay —What dealer is willing to pay – Asked PriceAsked Price—What sellers are willing to accept—What sellers are willing to accept

Perfectly competitive markets trade at Perfectly competitive markets trade at equilibrium price—bid and asked prices are equilibrium price—bid and asked prices are identical.identical.

Wider bid-asked spreads indicate high Wider bid-asked spreads indicate high transaction costs, lack of information and transaction costs, lack of information and transaction prices will differ from equilibrium transaction prices will differ from equilibrium pricesprices

Measure of LiquidityMeasure of Liquidity

Dealer will quote a narrow bid-asked spread if:Dealer will quote a narrow bid-asked spread if:– Expected value of transactions is largeExpected value of transactions is large– Expected risk of large equilibrium price change is lowExpected risk of large equilibrium price change is low– Competitive pressures from other dealersCompetitive pressures from other dealers

Although the spread is shown as a Although the spread is shown as a dollar amountdollar amount, , comparison with the price indicates the comparison with the price indicates the percentage percentage variationvariation

In general, higher transaction costs forIn general, higher transaction costs for equities equities result in result in a larger spread which reflects the greater risk of price a larger spread which reflects the greater risk of price fluctuation fluctuation

Ability of a market to handle large Ability of a market to handle large trades of institutional investorstrades of institutional investors

Does a large buy/sell order shift demand/supply Does a large buy/sell order shift demand/supply curve and significantly alter the equilibrium pricecurve and significantly alter the equilibrium priceCharacteristics of a Characteristics of a stable marketstable market—low price —low price volatilityvolatility– Depth of marketDepth of market—easy to uncover buy/sell orders —easy to uncover buy/sell orders

above and below current pricesabove and below current prices– Breadth of marketBreadth of market—orders above/below current —orders above/below current

prices exist in large volumeprices exist in large volume– Resilience of marketResilience of market—new orders quickly pour in —new orders quickly pour in

which prices move up or downwhich prices move up or down

Efficiency of Secondary Efficiency of Secondary Market TradingMarket Trading

Thin MarketsThin Markets —only a small volume of trading —only a small volume of trading can be absorbed without causing wide price can be absorbed without causing wide price swingsswings

Equilibrium price changes are part of Equilibrium price changes are part of everyday price movementeveryday price movement– Reflect basic changes in supply/demandReflect basic changes in supply/demand– Readily available information permits traders to Readily available information permits traders to

continuously monitor prices and quickly enter the continuously monitor prices and quickly enter the market when prices deviate from equilibriummarket when prices deviate from equilibrium

– Contributes to price stability and liquidityContributes to price stability and liquidity

Efficient Capital MarketsEfficient Capital Markets

Current price of a security reflects all publicly Current price of a security reflects all publicly available informationavailable information

Changes in information will cause the Changes in information will cause the demand/supply curves to shift, resulting in a demand/supply curves to shift, resulting in a change in the expected equilibrium pricechange in the expected equilibrium price– Can individual investors earn above-average returns Can individual investors earn above-average returns

by trying to “second-guess” the market?by trying to “second-guess” the market?

– Security analysts and stock-brokerage firms advertise Security analysts and stock-brokerage firms advertise they can “out-perform” the marketthey can “out-perform” the market

Securities and Exchange Act of 1934Securities and Exchange Act of 1934

Created the Securities and Exchange Created the Securities and Exchange Commission (SEC)Commission (SEC)– Established to prevent fraud and promote Established to prevent fraud and promote

equitable and fair operations in securities equitable and fair operations in securities marketmarket

– Despite the scrutiny of the SEC, investors, Despite the scrutiny of the SEC, investors, and traders—manipulation, fraud, and traders—manipulation, fraud, misinformation, and deception still exist in the misinformation, and deception still exist in the marketmarket

The Securities and Exchange The Securities and Exchange Commission (SEC)Commission (SEC)

Require full disclosure of information that Require full disclosure of information that might be relevant for valuing a securitymight be relevant for valuing a securityBan misinformation and dissemination of Ban misinformation and dissemination of false or misleading reportsfalse or misleading reportsProhibit the use of insider information Prohibit the use of insider information