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 investors—usually 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 • 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

10. 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

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 NASDAQ—National 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 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

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 (seller’s supply curve) and an offer price at which they will sell (buyer’s demand curve)

16. 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.

17. 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

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 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

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 traders—manipulation, 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