The Structure and Performance
of Securities Markets
Chapter 6
Nature and Function
of Securities Markets
All markets bring sellers and buyers together
Price balances supply and demand for the
securities by all potential market participants
Key role of markets is to provide information to
buyers/sellers
Markets reduce transaction costs
– Buyers and sellers may be unaware of each other
– Different locations
– Different times
Primary vs. Secondary Markets
Primary Markets
– Deal in newly issued securities
Secondary Markets
– Deal in existing securities
Primary Markets
Investment Banks
Underwritings
– Underwriting spreads
Tombstone Ads
Trading in this market is not in a physical
market, but electronically or personally
between the investment bankers and
ultimate investors—usually large
institutional investors
Theglobe.com
Dallas Morning News
– Monday, April 19, 1999
From Start to Finish:
– The seven steps of the IPO process, and how
theglobe.com specifically went from “bake-off”
to completion.
Initial Public Offerings
www.ipocentral.com
Secondary Markets
Three main types:
– Auction Market
– Brokered Market
– Dealer Market
Market orders vs. Limit orders
Auction Market
Buyers and sellers confront each other directly
to set the price
Either a single trade between all parties at a
single price or a series of trades at different
prices
Particular rules of the auction determine exactly
how buyers and sellers are matched up.
All buy/sell orders are centralized so highest
bidders and lowest offers are exposed to each
other
Auction Market
Posts—Specific locations where auctions
for individual securities take place
Specialists—Individual designated by the
exchange to represent buy/sell orders
tendered by customers
NYSE
AMEX
Brokered Market
Buyers/sellers employ services of a broker to
search for information about the “other side” of
the trade
Broker’s role is to provide information
Brokers earn a commission
Real estate brokers—provide information for
buyers/sellers of homes
Municipal bonds are traded primarily in a
brokered market
Dealer Market
Security dealers sell/buy for their own account
Help to stabilize the market
Commit own capital in process of bringing
sellers and buyers together
Expect to earn a profit by “buying low and selling
high”
Take a risk on a change of price in the securities
they own
Dealer Markets
Most securities trade in dealer markets
Over-the counter (OTC)
– Network of dealers linked together by
telephone or computers
– Most trades take place in a partially
automated electronic stock market called
NASDAQ—National Association of Security
Dealers Automated Quotation System
Dealer Markets
Organizational structure of a dealer market
and technological information keep
transaction prices as close to true
equilibrium as is economically feasible
Good marketability of a security implies it
can be sold, liquidated, and turned into
cash very quickly without a collapse in
price
Efficiency of Secondary
Market Trading
Efficient markets result in a transaction price
close to true equilibrium price—highly liquid
Low transaction costs-timely information
Walrasian auction
– Auctioneer announces the price and asks
buyers/sellers to submit quantities they want to buy or
sell
– If not equal, auctioneer raises or lowers price until the
market clears—quantity demanded is equal to
quantity supplied
– Exchange occurs at single equilibrium price
Efficiency of Secondary
Market Trading
Financial markets operate differently with
transactions occurring continuously
throughout the day at different prices
Dealers (market makers) quote a bid
price at which they will buy (seller’s supply
curve) and an offer price at which they will
sell (buyer’s demand curve)
Efficiency of Secondary
Market Trading
Dealer’s objective is to sell inventory that
has been purchased before the equilibrium
price has an opportunity to change
Since buyers/sellers are concerned that
equilibrium price might change before the
auction occurs, they may chose to transact
at dealer’s bid and offer price.
Measure of Liquidity
Spread between bid and asked prices
– Bid Price—What dealer is willing to pay
– Asked Price—What sellers are willing to accept
Perfectly competitive markets trade at
equilibrium price—bid and asked prices are
identical.
Wider bid-asked spreads indicate high
transaction costs, lack of information and
transaction prices will differ from equilibrium
prices
Measure of Liquidity
Dealer will quote a narrow bid-asked spread if:
– Expected value of transactions is large
– Expected risk of large equilibrium price change is low
– Competitive pressures from other dealers
Although the spread is shown as a dollar amount,
comparison with the price indicates the percentage
variation
In general, higher transaction costs for equities result in
a larger spread which reflects the greater risk of price
fluctuation
Ability of a market to handle large
trades of institutional investors
Does a large buy/sell order shift demand/supply
curve and significantly alter the equilibrium price
Characteristics of a stable market—low price
volatility
– Depth of market—easy to uncover buy/sell orders
above and below current prices
– Breadth of market—orders above/below current
prices exist in large volume
– Resilience of market—new orders quickly pour in
which prices move up or down
Efficiency of Secondary
Market Trading
Thin Markets —only a small volume of trading
can be absorbed without causing wide price
swings
Equilibrium price changes are part of
everyday price movement
– Reflect basic changes in supply/demand
– Readily available information permits traders to
continuously monitor prices and quickly enter the
market when prices deviate from equilibrium
– Contributes to price stability and liquidity
Efficient Capital Markets
Current price of a security reflects all publicly
available information
Changes in information will cause the
demand/supply curves to shift, resulting in a
change in the expected equilibrium price
– Can individual investors earn above-average returns
by trying to “second-guess” the market?
– Security analysts and stock-brokerage firms advertise
they can “out-perform” the market
Securities and Exchange Act of 1934
Created the Securities and Exchange
Commission (SEC)
– Established to prevent fraud and promote
equitable and fair operations in securities
market
– Despite the scrutiny of the SEC, investors,
and traders—manipulation, fraud,
misinformation, and deception still exist in the
market
The Securities and Exchange
Commission (SEC)
Require full disclosure of information that
might be relevant for valuing a security
Ban misinformation and dissemination of
false or misleading reports
Prohibit the use of insider information