Primary markets are where issuers first sell their securities to investors. For example, when a private company goes public, its shares are issued first to the investors in the primary market before it starts trading in the secondary market.
Issuers generally contract with an investment bank to help them sell their securities to the public. The investment bank builds the list of subscribers who will buy the security. This process is known as book building. Investment banks attract investors by providing investment information and opinion about the issuing company.
In an accelerated book build, issuers may issue securities with the help of an investment bank in only one or two days.
The two major types of offerings provided by investment banks are the underwritten offering and the best efforts offering.
An IPO (Initial Public Offering) is where issuers sell securities to the public for the first time.
A seasoned or secondary offering is where an issuer sells additional units of a previously issued security. As an example a company might have raised $10 million through an IPO and four years later wants to raise another $15 million through a secondary offering. Note that the secondary offering is a transaction between the issuer and investors.
A private placement is where corporations sell securities directly to a small group of qualified (sophisticated) investors as opposed to the public. Private placement requires relatively low disclosure requirements because qualified investors are aware of the risks involved. It is less costly than a public offering.
In a shelf registration, corporations sell seasoned securities directly to the public on a piecemeal basis over time instead of selling it in a single transaction. They are sold in secondary markets. Consider a publicly traded company that announces the sale of 700,000 shares to a small group of qualified investors at €0.75 per share. This is an example of a private placement and not shelf registration because the company is not selling on a piecemeal basis.
In a rights offering, companies distribute the right to buy new stock at a fixed price to existing shareholders in proportion to their holdings. For example, a publicly traded Italian company is raising new capital. Its existing shareholders may purchase three shares for €3.07 per share for every 10 shares they hold.
Primary markets are where entities raise money. Secondary markets are markets where investors trade (buy/sell) in securities. The cost of raising capital in primary markets is lower for corporations and governments whose securities trade in liquid secondary markets. In a liquid market, the transaction costs are low to buy/sell a security. Since investors value liquidity, they are willing to pay more for liquid securities. These high prices result in lower costs of capital for issuers.
Trading in securities takes place in a variety of structures. We will consider three aspects of market structure:
The two categories of securities market based on when they are traded are as follows:
The example below illustrates how a large order is filled in a continuous trading market.
At the start of the trading day, the limit order book for stock X looks as follows:
|Buyer||Bid Size||Limit Price ($)||Offer Size||Seller|
Tom submits an order to buy 150 shares, limit $34. What is the impact on the limit order book?
Tom has placed a marketable limit order. He will buy 40 shares from Sam and 60 shares from Simon as these satisfy the limit price criteria of at or below $34. He will not buy from Sue as hers is a limit order of $34. Only 100 shares are filled; 50 remain unfilled.
Average price = 0.4 x 33 + 0.6 x 34 = 33.6
In the limit order book, Tom is a buyer with bid size of 50 at a price of $34. Sam and Simon’s orders are removed from the limit order book as they are filled. It looks like this:
|Buyer||Bid Size||Limit Price (in $)||Offer Size||Seller|
The three categories of the securities market based on how they are traded are as follows:
The two categories of the securities market based on when the information is disclosed are as follows:
Why do we need a well-functioning financial system?
Four characteristics of a well-functioning financial system include:
The role of a market regulator is to ensure fair trading practices. The objectives of market regulation are to: