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

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 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 NASDAQ

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