Chapter 6
The Structure and
Performance of
Securities Markets

CHAPTER OUTLINE
I.
II.
The Nature and Function of Securities Markets
A. Auction market
B. Brokered market
C. Dealer market
D. Primary versus secondary markets
Efficiency and Secondary Market Trading
III. Efficient Capital Markets and Regulation

CHAPTER SUMMARY
The structure of markets plays an important role in determining the prices at which economic goods trade
and the ways in which market participants interact. The equilibrium price that emerges from a
supply-demand picture assumes that all sellers and buyers are brought together in the same marketplace
and that transactions only occur at the equilibrium price. This is not always the case. Securities auction
markets, however, offer perhaps the closest real-world approximation of the theoretical ideal. Yet, even
auction markets involve transactions costs that cause real-world prices to differ from the theoretical
equilibrium prices of securities. More efficient markets have lower transactions costs, often measured as
the difference between the bid and ask prices of the security (the bid-ask spread). A narrow bid-ask spread
produces transactions prices that are close to theoretical equilibrium prices. Most security transactions are
secondary transactions and occur in secondary markets (e.g., the New York Stock Exchange). These
transactions and markets involve the buying and selling of existing securities. In contrast, primary
transactions and markets involve newly issued securities. Virtually all corporations use investment banks to
place these new issues with investors.
A vital role played by securities markets is that of information processor. Most evidence suggests that
current market prices reflect all publicly available information about the current and expected future
returns from the securities. Regulatory supervision by the Securities and Exchange Commission attempts to
ensure fair and equitable trading that is free of fraud.

TEACHING
This chapter is not essential for understanding other portions of the text, but it is likely to generate a good
deal of student interest. Potential volatility of financial markets is an important topic. The mechanics of
buying and selling securities may grab their attention. Stress the distinctions between (1) transactions price
and equilibrium price, and (2) operational efficiency and allocational efficiency. Point out the role of
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16  Ritter/Silber/Udell Money, Banking, and Financial Markets, Eleventh Edition
regulation and the reasons for insider-trading laws and the difference between inside trading and
attempting to gain a “fair” informational advantage on other investors.
You might want to go a little deeper into the supply-and-demand analysis of dealer-made markets. For
example: how an inaccurate straddle of the equilibrium price causes inventory buildup or depletion. If this
takes, then try showing what happens to the dealer with a large change in the equilibrium price.
The recent rapid decline in stock prices (the bursting “bubble”) is also likely to generate lots of interest. It
is also highly instructive for understanding how auction markets work. If sellers greatly outnumber buyers,
the price falls “all at once” until equilibrium is re-established.
Useful Internet sites
2.
www.oecd.org — Contains information of leading indicators and on the workings of government
securities markets in OECD countries.
http://www.nyse.com/home.html — NYSE website contains stock quotes and other information.

DISCUSSION QUESTIONS
1.
1.
Why is the sale of cars usually handled by dealers and the sale of real estate by brokers?
Costs of maintaining an inventory.
2.
Did the stock market crashes of October 1987 and of 2001 prove that capital markets are not
efficient?
No, prices may reflect full information about expected future earnings and still turn out to
be very wrong. That is, expectations need not be realized. Moreover, many economists
admit to the possibility of speculative bubbles.
3.
Why have successful investment bankers received such high incomes lately? What service do they
perform?
Investment bankers exist because the reduce transactions cost. Even though they
themselves may cost a lot, they are cheaper than trying to do the deals without them. The
more activity in areas such as bond issues, mergers and acquisitions, initial public offerings,
the more income is generated for the deal makers – i.e., the investment bankers.
4.
What characterizes securities with wide bid-asked spreads?
Relatively low trading volume and other transactions costs.

1.
ANSWERS TO QUESTIONS IN TEXT
The main feature of an auction market is that participants confront each other directly. Brokered
markets have sellers employing agents to search for buyers. A dealer market has a dealer continuously
buying and selling and taking positions. In all three markets resources are devoted to uncovering
mutually beneficial trades.
2.
A dealer will quote a narrow bid-asked spread if the expected volume of transactions is large and
the risk of large price changes is low. Though dealers would, of course, always like to quote wide spreads,
competition among dealers enforces a discipline on their ability to set wide spreads.
3.
The market for U.S. Treasury bonds is characterized by the ease of uncovering buyer and seller
orders above and below the current transactions prices. It is a “deep, broad, resilient” (i.e., lots of buyers
and sellers) market, indicating low transactions costs.
4.
If markets are truly efficient and absorb all public information very quickly, there is nothing to gain
from buying and selling securities on the basis of widely available information.
5.
One or more investment bankers will underwrite the security and make an informal primary market
for it by distributing it to investors. Before the distribution they provide information about its likely
demand and bear the risk of price fluctuation.
6.
The fee received by investment bankers will probably be associated with the risks and transactions
costs involved in placing the securities with investors. Larger issues of better-known, highly rated
Chapter 6 The Structure and Performance of Securities Markets  17
corporations are likely to have lower underwriting fees (spreads) than smaller issues of less well-known,
lower-rated corporations. Also, like any other service or good, when demand is high relative to supply the
price (in this case the spread) will rise.

1.
ESSAY QUESTIONS
What are the differences between brokered and dealer markets? Would the New York Stock Exchange
fit into one of these categories?
Brokers provide information and receive a commission, and brokered markets require this.
Dealer markets have participants ready to buy and sell continuously, thus taking a position.
The NYSE has elements of both a dealer and a brokered market.
2.
Describe the typical procedure in issuing new corporate equity. What role do investment banks
play?
The issuer will select one or more investment banks to underwrite the new shares. Then the
banks will distribute them to institutional investors. The banks produce information and
bear the risk of price fluctuations in the stock before they can sell them.
3.
What is a meant by an efficient secondary market? How is its efficiency measured?
Efficient markets have low transactions costs, as measured by the bid-asked spread.
4.
Why does over-the-counter stock have wider bid-asked spreads than do U.S. Treasury bills?
Because the volume of transactions in Treasuries is greater and the risk of large changes in
equilibrium price is smaller.