1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 6 The Structure and Performance of Securities Markets

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-2 Learning Objectives Differentiate the types of financial markets including auction, brokered, and dealer markets Describe the differences and functions of the primary and secondary markets Understand the function and determination of bid/ask spreads Explain the efficient market hypothesis and its relevance to the allocation efficiency of financial markets

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-3 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

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-4 Nature and Function of Securities Markets (Cont.) In real world, prices that approach the true equilibrium is best we can hope for Security markets are organized to bring buyers and sellers together, so both parties will be satisfied that a fair transaction price has been arranged 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

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-5 Nature and Function of Securities Markets (Cont.) Auction Market (Cont.) –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 –Most popular example of a securities auction market is the New York Stock Exchange Posts—Specific locations where auctions for individual securities take place Specialists—Individual designated by the exchange to represent buy/sell orders tendered by customers

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-6 Nature and Function of Securities Markets (Cont.) Brokered Markets –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

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-7 Nature and Function of Securities Markets (Cont.) Dealer Markets –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

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-8 Nature and Function of Securities Markets (Cont.) Dealer Markets (Cont.) –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 New York Stock Exchange is a cross between a dealer market and an auction market.

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-9 Nature and Function of Securities Markets (Cont.) Dealer Markets (Cont.) –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

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-10 Nature and Function of Securities Markets (Cont.) Primary Versus Secondary Markets –Secondary Market Deal in existing securities (second-hand markets) Examples—New York Stock Exchange and Tokyo Stock Exchange

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-11 Nature and Function of Securities Markets (Cont.) Primary Versus Secondary Markets (Cont.) –Primary Markets Deal in newly issued securities Investment Banks –Distribute newly issued stocks and bonds to investors –Also trade in the secondary market –Dissemination of information to issuer and potential buyers about price and trading –Underwriting—Investment bank guarantees a price on the new issue

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-12 Nature and Function of Securities Markets (Cont.) Primary Versus Secondary Markets (Cont.) –Primary Markets (Cont.) Investment Banks (Cont.) –Underwriting Spread—Fee earned by investment bankers –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 –Tombstone—Announcements of successful underwritings (Figure 6.1a)

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-13 Newspaper advertisement (A “tombstone”) An underwriting syndicate floats a new issue. Source: Wall Street Journal, November 26, 2002

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-14 Nature and Function of Securities Markets (Cont.) Primary Versus Secondary Markets (Cont.) –A close interrelationship between prices and yields on securities in secondary markets and those in primary markets –High prices in the secondary market will generally indicate high prices can be expected with primary issues

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-15 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

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-16 Efficiency of Secondary Market Trading (Cont.) 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)

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-17 Efficiency of Secondary Market Trading (Cont.) 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.

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-18 Efficiency of Secondary Market Trading (Cont.) Measure of Liquidity –Spread between bid and asked prices Bid Price—What dealer is willing to pay (supply curve) (Figure 6.1) Asked Price—What sellers are willing to accept (demand curve) (Figure 6.1) –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 considerable from equilibrium prices

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-19 FIGURE 6.1 Bid-asked spreads cause actual transactions prices to hover about the true equilibrium price.

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-20 Efficiency of Secondary Market Trading (Cont.) Measure of Liquidity (Cont.) –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

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-21 Efficiency of Secondary Market Trading (Cont.) 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

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-22 Efficiency of Secondary Market Trading (Cont.) 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

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-23 Efficient Capital Markets and Regulation Efficient Capital market—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 The issue is how quickly does the market absorb new information, resulting in a price change 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

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-24 Efficient Capital Markets and Regulation (Cont.) The Securities and Exchange Commission (SEC) –Established to prevent fraud and promote equitable and fair operations in securities market –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 for personal gain of individuals, brokers and dealers

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-25 Efficient Capital Markets and Regulation (Cont.) The Securities and Exchange Commission (SEC) (Cont.) –Despite the scrutiny of the SEC, investors, and traders—manipulation, fraud, misinformation, and deception still exist in the market –Caveat emptor et venditor—buyers/sellers beware—necessary precautions to ensure market efficiency

26. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-26 TABLE 6.1 Sample Bid and Asked Quotations on Securities