Chapter 18 Secondary Markets  

In secondary markets, the issuer of the asset does not receive funds from the buyer. Existing issue changes hands in the secondary market, and funds from the buyer of the asset to the seller.
  • common features that the trading of any type of financial instruments
  • The chapter explains different aspects of secondary markets.

The Function of Secondary Markets

  • The issuer of securities can obtain regular information about the value of the asset.
  • opportunity for the original buyer of an asset to reverse the investments by selling it for cash.
  • periodic trading of the asset is shown to the issuer the consensus price that the asset in the open market.
    • Firms can discover what value investors attach to their stock, and firm or non-corporation issuers can observe the price of their bonds and implies interest rates investors expect and demand from them.
    • Benefits from secondary markets;
      • offers liquidity for assets/ also information about eh assets’ fair or consensus value.
      • keep the cost of transaction low

Structure of Secondary markets

  • Two different structures (Order- driven & quote-driven markets)

Potential parties to a trade

  1. natural buyers- want to take a position for their own portfolio, can be retail investors or institutional investors.
  2. natural sellers - same as natural buyers
  3. brokers- the third part of a trade that acts on behalf of a buyer or seller who wished to execute an order. ^^(doesn’t buy or sell but receives, transmits, and executes orders )^^
  4. dealers - an entity that acts as an intermediary in a trade by buying and selling for its own account.

   

  1. basically buys assets to place in inventory or sells an asset from its own inventory.
  2. Acts as a principle in a trade
  3. Income earned = potential income earned ^^(ask price)^^ and the price the dealer is willing to offer to the asset to the investor (^^bid price)^^ The difference between those two is called the ^^Bid-ask spread^^.

Specials type of dealer = market maker- the dealer that has a special obligation in the secondary market. used capital to make an orderly market for designated financial assets.

Order-Driven Markets and Quote Driven Markets

difference between these two is based on how trading takes place and how the price is determined.

  • order-driven market- all the participants in the trade are natural buyers and sellers- no dealers as intermediaries.
    • AKA= Auction market
  • quote-driven market- price is determined by the dealer and is based on prevailing market information.
    • AKA= dealer market or dealership market

Types of order-driven markets

can be further explained as a continuous order driven to market or periodic call auction.

  • continuous order-driven market- prices are determined continuously throughout the trading day as buyers and sellers submit orders.

    • may vary with the pattern of orders reaching the market and not because of any change in the basic situation of supply and demand.

  • periodic call auction- orders are batched or grouped together for simultaneous execution at pre-announced times.

    • Can be oral or written - which will determine the '“fix” the market clearing price at a particular time of the trading day.

  • price scan auction- an auctioneer announces tentative prices and the participants physically present respond indication of how much they would be willing to buy and sell at each tentative price.

  • sealed bid/ask auction- bid price/ask price and the quantities a participant is willing to transact are submitted.

    • market clearing price is the price at which the cumulated buy order equals the cumulated sell orders.

  • Immediacy- buyers and sellers do not want to wait for the arrival of sufficient orders on the other side of the trade, which would bring the price closer to the level of recent transactions.

    • Limit orders- special orders that can be executed only if the market price of the asset change is specific.
    • specialists- a privileged position, from which they get special information about the flow of market orders.
    • dealers position- carrying an inventory of security (long position) or selling a security that is not in inventory (short position).

  The risk of maintaining long or short positions in securities

  

  1. uncertainty about the future price of the security (dealers trade on their own account, brokers trade for someone else account )
  2. the expected time it will take the dealer to unwind a position and its uncertainty.

Market efficiency

  • operationally efficient market- investors can get transaction services as cheaply as possible, given the cost of furnishing those services.
    • transactions cost more than just brokerage commission- its commission fees, execution cost, and opportunity cost.
    • other fees: custodial fees ( charged by a financial entity that holds securities in safekeeping for investors)
    • Hidden cost when trading as well.
      • execution cost- the difference between the execution price of a security and the price that would have existed in the absence of the trade.
      • Market impact cost (impact cost)- the result of the bid-ask spread and a price concession extracted by the dealer to mitigate the risk that an investor will have to pay a higher price when buying and a lower price when selling.
      • Market timing cost- arises when an adverse price movement of the security during the tie of the transaction can be attributed in part to other activity in the security and is not the result of a particular transaction.

Price Efficiency

  • price efficiency- a market where prices at the time fully reflect all available information that is relevant to the valuation of securities.
    • Determine if the market is price efficient

     1. price fully reflects information 2. the relevant set of information that assumes that fully reflected in price must be defined.

  • weak efficiency- the price of the security reflects the past price and trading history of the security.
  • semi-strong efficiency- the price of the security fully reflects all public information, which includes but is not limited to historical price and trading patterns.
  • strong efficiency - a market where the price of a security reflects all information, regardless of whether it is publicly available.