Securities Markets

We can examine securities transactions from several perspectives from the points of view of dealers, brokers, investment bankers, and other participants in securities markets. In this chapter we will also examine characteristics of the markets and some important investment strategies.

Primary markets and investment banking

The markets that deal with newly issued securities are called primary markets. These markets perform an important economic function. Savings of individuals are channeled to companies that use the funds to purchase new capital (for example, plant and equipment). In return, new securities are issued to savers, either directly or indirectly through financial intermediaries (such as financial institutions or mutual funds).

In primary markets, organizations called investment bankers specialize in the marketing of new securities. Investment bankers perform two functions: advising and underwriting. The investment banker acts as an advisor to corporations that plan to issue new securities, and in this capacity counsels the issuer on the types of debt and equity securities that can be sold. In the case of bonds, required interest rates, possible maturities, and other terms of the issue would be considered. When equity is to be sold, the impact of new shares on the current stock price would be examined. In the planning process the investment banker and the corporation also consider the proper time to issue securities in light of existing supply and demand conditions.

When investment bankers act as underwriters, they guarantee a specific price for the securities to be sold. This is done in an agreement with the corporation that states that they will buy the entire issue at a stated price per security and will deliver the proceeds to the issuer before a certain date. In such cases, investment bankers intend to resell the securities to the general public at a higher price and take the difference as their profits. However, security markets change quickly, and sometimes it is impossible to sell the entire issue without substantially lowering its price. An investment banker could end up either taking losses or buying some of the securities with its own capital.

Generally, investment bankers are only willing to underwrite issues from large and well-known firms. When small and less-known companies wish to sell securities, investment bankers may be willing to market the issue only on a "best efforts" basis. In these cases investment bankers are not underwriting, but merely pledging to do their best to sell the security. They receive a commission on securities sold, and the unsold securities are returned to the issuer.

Secondary markets: exchanges, dealers, and brokers

Existing securities, which have been sold to the public in primary markets, are also traded in secondary markets. These markets have an important economic function in the capital allocation process by providing liquidity for new issue buyers. Investors would be reluctant to purchase newly issued securities from corporations and governments unless there were secondary markets in existence to sell those securities for cash at a convenient time prior to maturity.

Secondary markets consist of two principal components: organized exchanges and the over-the-counter (OTC) market. On exchanges, such as the New York Stock Exchange, securities are bought and sold in a central location. When one investor sells, the securities are sold on the exchange floor by a broker to another investor. The proceeds go to the seller, not to the company that issued the security. On the over-the-counter market, trading is performed over the telephone by securities dealers who buy from and sell to investors.