What is Market

Chapter 4
 WHAT IS A MARKET?
 A market is the means through which buyers and
sellers are brought together to aid in the transfer of
goods and/or services.
 First, a market need not have a physical location
 Second, the market does not necessarily own the
goods or services involved. The market function by
providing information and facilities to aid in the
transfer of ownership.
 Finally, a market can deal in any variety of goods and
services
 Characteristics of a Good Market
 one attribute of a good market is timely and
accurate information on past transactions and
prevailing buy and sell orders.
 Another prime requirement is liquidity, the ability
to buy or sell an asset quickly and at a known,
 An asset’s likelihood of being sold quickly,
sometimes referred to as its marketability, is a
necessary, but not a sufficient, condition for
 liquidity. The expected price should also be fairly
certain, based on the recent history of
transaction prices and current bid-ask quotes.
 A component of liquidity is price continuity,
which means that prices do not change much
from one transaction to the next unless
substantial new information becomes available.
 A market with price continuity requires depth,
which means that there are numerous potential
buyers and sellers willing to trade at prices above
and below the current market price.
 Another factor contributing to a good market is the
transaction cost. Lower costs (as a percent of the
value of the trade) make for a more efficient market.
 An efficient market as one in which the cost of the
transaction is minimal. This attribute is referred to as
internal efficiency.
 Finally, a buyer or seller wants the prevailing market
price to adequately reflect all the information
available regarding supply and demand factors in the
market.
 that prevailing market prices reflect all available
information about the asset. This attribute is referred
to as external, or informational, efficiency
 PRIMARY CAPITAL MARKETS
 The primary market is where new issues of bonds,
preferred stock, or common stock are sold by
government units, municipalities, or companies who
want to acquire new capital.
 Government Bond Issues
 U.S. government bond issues are subdivided into
three segments based on their original maturities.
 Treasury bills are negotiable, non-interest-bearing
securities with original maturities of one year or
less. Treasury notes have original maturities of 2 to
10 years. Finally, Treasury bonds have original
maturities of more than 10 years
 Municipal Bond Issues
 New municipal bond issues are sold by one of
three methods: competitive bid, negotiation, or
private placement.
 Competitive bid sales typically involve sealed
bids. The bond issue is sold to the bidding
syndicate of underwriters that submits the bid
with the lowest interest cost in accordance with
the stipulations set forth by the issuer
 Negotiated sales involve contractual
arrangements between underwriters and issuers
wherein the underwriter helps the issuer
prepare the bond issue and set the price and has
the exclusive right to sell the issue.
 Private placements involve the sale of a bond
issue by the issuer directly to an investor or a
small group of investors (usually institutions).
 Specifically, in a competitive bid or a negotiated
transaction, the investment banker typically
underwrites the issue, which means the
investment firm purchases the entire issue at a
specified price
 relieving the issuer from the risk and responsibility of
selling and distributing the bonds. Subsequently, the
underwriter sells the issue to the investing public. For
municipal bonds, this underwriting function is performed
by both investment banking firms and commercial banks.
 The underwriting function can involve three services:
origination, risk-bearing, and distribution.
 Origination involves the design of the bond issue and
initial planning. To fulfill the risk bearing function, the
underwriter acquires the total issue at a price dictated by
the competitive bid or through negotiation and accepts
the responsibility and risk of reselling it for more than the
purchase price.
 Distribution means selling it to investors, typically with the
help of a selling syndicate that includes other investment
banking firms and/or commercial banks
Corporate Bond Issues
 Corporate bond issues are almost always sold
through a negotiated arrangement with an investment
banking firm.
 In a global capital market there has been an explosion
of new instruments, which means that the origination
function, which involves designing the characteristics
and currency for the security, is becoming more
important because the corporate chief financial
officer (CFO) may not be completely familiar with
the availability and issuing requirements of many new
instruments and the alternative capital markets
around the world.
 Investment banking firms compete for underwriting
business by creating new instruments that appeal to
existing investors and by advising issuers regarding
desirable countries and currencies. As a result,
Corporate Stock Issues
 For corporations, new stock issues are typically
divided into two groups: (1) seasoned equity issues,
and (2) initial public offerings (IPOs).
 Seasoned equity issues are new shares offered by
firms that already have stock outstanding additional
capital, it could sell additional shares of its common
stock to the public at a price very close to the
current market price of the firm’s stock.
 Initial public offerings (IPOs) involve a firm selling its
common stock to the public for the first time. At the
time of an IPO, there is no existing public market for
the stock; that is, the company has been closely held
 The underwriting of corporate issues typically
takes
 one of three forms: negotiated, competitive bids,
or best-efforts arrangements
 Alternatively, an investment banker can agree to
sell an issue on a best-efforts basis. This is
usually done with speculative new issues. In this
arrangement, the investment banker does not
underwrite the issue because it does not buy
any securities. The stock is owned by the
company, and the investment banker acts as a
broker to sell whatever it can at a stipulated
price. Because it bears no risk, the investment
banker earns a lower commission on such an
issue than on an underwritten issue.
 Private Placements
 Rather than a public sale using one of these
arrangements, primary offerings can be sold
privately.
 In such an arrangement, referred to as a private
placement, the firm designs an issue with the
assistance of an investment banker and sells it to a
small group of institutions
SECONDARY FINANCIAL MARKETS
 Liquidity
 Price Discovery through secondary market
 Market price volatility.
 Secondary Bond Markets
 The secondary market for bonds distinguishes
among those issued by the federal government,
municipalities, or corporations
Secondary Markets for U.S. Government
and Municipal Bonds
 The major market makers in the secondary
municipal bond market are banks and investment
firms. Banks are active in municipal bond trading
and underwriting of general obligation issues
since they invest heavily in these securities
Secondary Corporate Bond Markets
 Currently, all corporate bonds are traded over
the counter by dealers who buy and sell for their
own accounts. The major bond dealers are the
 large investment banking firms that underwrite
the issues: firms such as Goldman Sachs, J.P.
 Morgan, Barclay Capital, and Morgan Stanley.
Because of the limited trading in corporate
 bonds compared to the fairly active trading in
government bonds, corporate bond dealers do
 not carry extensive inventories of specific issues
 Financial Futures
 In addition to the market for the bonds, a market
has developed for futures contracts related to
these bonds. These contracts allow the holder to
buy or sell a specified amount of a given bond
issue at a stipulated price.
 Secondary Equity Markets
Basic Trading Systems
 There are two major trading systems, and an
exchange can use one or a combination of them.
One is a pure auction market (also referred to as
an order-driven market), in which interested
buyers and sellers submit bid-and-ask prices (buy
and sell orders) for a given stock to a central
location where the orders are matched by a
broker who does not own the stock but acts as a
facilitating agent. Participants also refer to this
system as price-driven because shares of stock
are sold to the investor with the highest bid
price and bought from the seller with the lowest
offering price
Dealer market
 (also referred to as a quote-driven market) where
individual dealers provide liquidity for investors by
buying and selling the shares of stock for
themselves. Ideally, with this system there will be
numerous dealers who will compete against each
other to provide the highest bid prices when you
are selling and the lowest asking price when you
are buying stock.
 Clearly, this is a very decentralized system that
derives its benefit from the competition among
the dealers who are connected by technology to
provide the best price for the buyer and seller