The Structure and Performance of Securities Markets

1
The Structure and Performance of Securities
Markets

• Chapter 6

2
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

3
Primary vs. Secondary Markets

• Primary Markets
• Deal in newly issued securities
• Secondary Markets
• Deal in existing securities

4
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
  investorsusually large institutional investors

5
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.

6
Initial Public Offerings

• www.ipocentral.com

7
Secondary Markets

• Three main types
• Auction Market
• Brokered Market
• Dealer Market
• Market orders vs. Limit orders

8
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

9
Auction Market

• PostsSpecific locations where auctions for
  individual securities take place
• SpecialistsIndividual designated by the exchange
  to represent buy/sell orders tendered by
  customers
• NYSE
• AMEX

10
Brokered Market

• Buyers/sellers employ services of a broker to
  search for information about the other side of
  the trade
• Brokers role is to provide information
• Brokers earn a commission
• Real estate brokersprovide information for
  buyers/sellers of homes
• Municipal bonds are traded primarily in a
  brokered market

11
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

12
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 NASDAQNational
  Association of Security Dealers Automated
  Quotation System

13
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

14
Efficiency of Secondary Market Trading

• Efficient markets result in a transaction price
  close to true equilibrium pricehighly 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 clearsquantity demanded is
  equal to quantity supplied
• Exchange occurs at single equilibrium price

15
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 (sellers supply curve) and
  an offer price at which they will sell (buyers
  demand curve)

16
Efficiency of Secondary Market Trading

• Dealers 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 dealers
  bid and offer price.

17
Measure of Liquidity

• Spread between bid and asked prices
• Bid PriceWhat dealer is willing to pay
• Asked PriceWhat sellers are willing to accept
• Perfectly competitive markets trade at
  equilibrium pricebid and asked prices are
  identical.
• Wider bid-asked spreads indicate high transaction
  costs, lack of information and transaction prices
  will differ from equilibrium prices

18
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

19
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 marketlow price
  volatility
• Depth of marketeasy to uncover buy/sell orders
  above and below current prices
• Breadth of marketorders above/below current
  prices exist in large volume
• Resilience of marketnew orders quickly pour in
  which prices move up or down

20
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

21
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

22
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
  tradersmanipulation, fraud, misinformation, and
  deception still exist in the market

23
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