How Securities Are Traded

How Securities Are Traded?
Financial Market
A Financial market is a mechanism through which financial assets are
traded. It is a virtual place through which deficit units meet with the
surplus units.
Financial market offers three major economic functions:
1. Price Discovery
2. Liquidity
3. Reduction of Transaction Cost
Price Discovery
 The function means that transactions between buyers and sellers of
financial instruments in a financial market determine the price of the
traded asset.
 At the same time the required return from the investment of funds is
determined by the participants in a financial market.
 The motivation for those seeking funds (deficit units) depends on the
required return that investors demand.
 Basically price will be determined by the market forces (demand and
supply).
Liquidity
 Liquidity function provides an opportunity for investors to sell a
financial instrument, since it is referred to as a measure of the ability
to sell an asset at its fair market value at any time.
 Without liquidity, an investor would be forced to hold a financial
instrument until conditions arise to sell it or the issuer is contractually
obligated to pay it off.
Reduction of Transaction Cost
 Cost of searching (search cost)
 Cost of information asymmetry
Primary Market Versus Secondary Market
 In the primary market, a financial instrument is first issued or sold. For
example: IPO, RPO/SO (Repeat Public Offering/ Seasonal Offering).
 A secondary market is such in which financial instruments are resold
among investors. No new capital is raised by the issuer of the security.
Trading takes place among investors. For example: DSE, CSE etc.
Third Market
 OTC (Over the Counter): In OTC market, unlisted financial
instruments are traded.
Money Market vs Capital Market
 In money market, financial instruments having maturity of maximum
one year or less than one year are traded. For example: Market for
treasury bill, commercial paper, repurchase agreements (REPO).
 The capital market is the sector of the financial market where long-
term financial instruments issued by corporations and governments
trade. Here “long-term” refers to a financial instrument with an
original maturity greater than one year and perpetual securities (those
with no maturity).
Money Market vs Capital Market (cont..)
• There are two types of capital market securities: those that represent
shares of ownership interest, also called equity, issued by corporations,
and those that represent indebtedness, or debt issued by corporations
and by the state and local governments.
Cash Market vs Derivative Market
• The cash market, also referred to as the spot market, is the market for
the immediate purchase and sale of a financial instrument.
• In contrast, some financial instruments are contracts that specify that
the contract holder has either the obligation or the choice to buy or sell
another something at or by some future date. The “something” that is
the subject of the contract is called the underlying (asset). The
underlying asset is a stock, a bond, a financial index, an interest rate, a
currency, or a commodity.
Cash Market vs Derivative Market (cont..)
• Because the price of such contracts derive their value from the value
of the underlying assets, these contracts are called derivative
instruments and the market where they are traded is called the
derivatives market.
Market from the Level of Organization
Direct Search Market
 A direct search market is the least organized market. Buyers and
sellers must seek each other out directly.
 An example of a transaction in such a market is the sale of a used
refrigerator where the seller advertises for buyers in a local newspaper
or on Craigslist.
 Such markets are characterized by sporadic participation and low-
priced and nonstandard goods. Firms would find it difficult to profit
by specializing in such an environment.
Brokered Market
 The next level of organization is a brokered market. In markets where
trading in an asset is active, brokers find it profitable to offer search
services to buyers and sellers.
 A good example is the real estate market, where economies of scale in
searches for available homes and for prospective buyers make it
worthwhile for participants to pay brokers to help them conduct the
searches.
Brokered Market (cont…)
 Brokers in particular markets develop specialized knowledge on
valuing assets traded in that market.
 Notice that the primary market, where new issues of securities are
offered to the public, is an example of a brokered market.
 In the primary market, investment bankers who market a firm’s
securities to the public act as brokers; they seek investors to purchase
securities directly from the issuing corporation.
Dealer Market
• When trading activity in a particular type of asset increases, dealer
markets arise. Dealers specialize in various assets, purchase these
assets for their own accounts, and later sell them for a profit from their
inventory.
• The spreads between dealers’ buy (or “bid”) prices and sell (or “ask”)
prices are a source of profit.
Dealer Market (cont…)
• Most bonds trade in over-the-counter dealer markets.
• Dealer markets save traders on search costs because market
participants can easily look up the prices at which they can buy from
or sell to dealers.
• Quote driven market
Auction Market
• The most integrated market is an auction market in which all traders
converge at one place (either physically or “electronically”) to buy or
sell an asset.
• The New York Stock Exchange (NYSE) is an example of an auction
market.
• An advantage of auction markets over dealer markets is that one need
not search across dealers to find the best price for a good. If all
participants converge, they can arrive at mutually agreeable prices and
save the bid–ask spread.
• Order driven market.
Order Driven Market Vs. Quote Driven Market
Order Driven Market
• The order-driven market displays all of the bids and asks.
• If you place an order for 100 shares of ABC stock at $30 per share,
your order will be displayed in the market and can be seen by people
with access to this level of information.
• The biggest advantage to this system is its transparency: It clearly
shows all of the market orders and what price people are willing to
buy at or sell for.
Quote Driven Market
• The quote driven market focuses only on the bids and asks of market
makers.
• These market makers will post the bid and ask price that they are
willing to accept at that time.
• In this market, your order for 100 shares of ABC stock at $30 per
share will not be seen in the market.
• However, if there were one market maker for the stock, it would post
its bid – say, $29.50 – and its ask – say, $30.50. (That is all that would
be displayed in the market, unless there were more than one market
maker, in which case you could see more than one bid or ask offer.)

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