Transcript Dealer Markets (Cont.)

Chapter 6
The Structure
and Performance
of Securities
Markets
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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6-2
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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6-3
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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6-4
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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6-5
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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6-6
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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6-7
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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6-8
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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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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6-10
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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6-11
Figure 6.1a
Newspaper
advertisement
(A “tombstone”)
An underwriting syndicate floats a new
issue. Source: Wall Street Journal,
November 26, 2002
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6-12
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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6-13
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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6-14
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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6-15
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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6-16
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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Figure 6.1 Bid-asked spreads cause actual
transactions prices to hover about the true
equilibrium price
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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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6-19
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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6-20
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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6-21
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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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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6-23
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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