Transcript The Structure and Performance of Securities Markets

Chapter 6
The Structure
and
Performance
of Securities
Markets
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
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
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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
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6-3
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
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6-4
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
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6-5
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
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6-6
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
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6-7
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.
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6-8
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
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6-9
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
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6-10
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
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6-11
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)
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6-12
Newspaper advertisement
(A “tombstone”)
An underwriting syndicate floats a new
issue. Source: Wall Street Journal,
November 26, 2002
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6-13
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
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6-14
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
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6-15
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)
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6-16
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.
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6-17
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
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6-18
FIGURE 6.1 Bid-asked spreads cause actual
transactions prices to hover about the true
equilibrium price.
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6-19
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
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6-20
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
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6-21
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
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6-22
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
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6-23
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
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6-24
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
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6-25
TABLE 6.1 Sample Bid and Asked
Quotations on Securities
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