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Unit-2 : Markets Classification and Trading Mechanics

2.1 The Primary Market
2.2 Secondary Market
2.3 Money Market
2.4 Capital Market Page | 1
2.5 Regulation of the issuance of Securities
2.6 Role of brokers and Dealers in Markets
2.7 Variations in the Underwriting of Securities
2.8 World Capital Markets Integration and Fund Raising Implications
2.9 Motivation for Raising Funds outside of the Domestic Market
2.10 Function of Secondary Markets
2.11 Trading Locations
2.12 Market Structures
2.13 Secondary Market Trading Mechanic
2.14 Market Efficiency
2.15 Transaction Costs

A study on the primary vs. secondary market gives information on the various
aspects of the capital market trading. Both the primary market and secondary
market are two types of capital market depending on the issuance of securities.
2.1-Primary Market Definition:
The primary markets deal with the trading of newly issued securities. The
corporations, governments and companies issue securities like stocks and bonds
when they need to raise capital. The investors can purchase
the stocks or bonds issued by the companies.
Money thus earned from the selling of securities goes directly to the issuing
company. The primary markets are also called New Issue Market (NIM). Initial
Public Offering is a typical method of issuing security in the primary market. The
functioning of the primary market is crucial for both the capital market
and economy as it is the place where the capital formation takes place.
2.2-Secondary Market Definition:
The secondary market is that part of the capital market that deals with the
securities that are already issued in the primary market.
The investors who purchase the newly issued securities in the primary market sell
them in the secondary market. The secondary market needs to be transparent and
highly liquid in nature as it deals with the already issued securities. In the
secondary market, the value of a particular stock also varies from that of the face
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value. The resale value of the securities in the secondary market is dependent on
the fluctuating interest rates.
Primary vs. Secondary Market:
Primary vs. secondary market says that the primary market deals with the newly Page | 2
issued securities while the secondary market deals with already traded securities.
When the companies issue securities in the primary market, they collect funds
directly from the investors through the securities sales. But, in the secondary
market the money earned from selling a security does not go to the company. The
money thus earned goes to the investor who sells the security. The pricing in the
secondary market is entirely different from the pricing in the primary market.

2.3- Money Market: Money market the market for short-term debt securities
with maturities of less than one year.
A segment of the financial market in which financial instruments with high
liquidity and very short maturities are traded. The money market is used by
participants as a means for borrowing and lending in the short term, from several
days to just under a year. Money market securities consist of negotiable certificates
of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial
paper, municipal notes, federal funds and repurchase agreements (repos). The
money market is used by a wide array of participants, from a company raising
money by selling commercial paper into the market to an investor purchasing CDs
as a safe place to park money in the short term. The money market is typically seen
as a safe place to put money due the highly liquid nature of the securities and short
maturities, but there are risks in the market that any investor needs to be aware of
including the risk of default on securities such as commercial paper.

2.4- Capital Market: The part of a financial system concerned with raising
capital by dealing in shares, bonds, and other long-term investments. So Capital
markets are the markets where securities such as shares and bonds are issued to
raise medium to long-term financing, and where the securities are traded. The
securities might be issued by a company which could issue shares or bonds to raise
money. Bonds could also be issued by other entities in need of long-term cash,
such as regional or national governments. The securities are issued in what is
known as the primary market and traded in the secondary market. In the primary
market a company would have face to face meetings to place its securities with
investors. A company might work with an investment bank that would act as an
intermediary and underwrite the offering. Capital markets are overseen by
the Securities and Exchange Commission in the United States or other financial
regulators elsewhere. Though capital markets are generally concentrated in

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financial centers around the world, most of the trades occurring within capital
markets take place through computerized electronic trading systems. Some of these
are accessible by the public and others are more tightly regulated.
2.5- Regulation of the issuance of Securities: Professional portfolio managers
are entrusted with the management of trillions of dollars. It is therefore not Page | 3
surprising that the investment industry is highly regulated to ensure a minimum
level of acceptable practice. These regulations, which often involve a complex
interaction between state and federal laws, are designed for the primary purpose of
ensuring that portfolio managers act in the best interests of their investors. At their
most basic level, regulations are written to promote adequate disclosure of
information related to the investment process and to provide various antifraud
protections. The primary purpose of these regulations and standards is to ensure
that managers deal with all investors fairly and equitably and that information
about investment performance is accurately reported.

2.6- Role of brokers and Dealers in Markets:

Brokers and dealers are terms associated with securities. Though both have almost
the same work, they are different in many aspects. The main difference between a
broker and a dealer is in respect of their role in the market, as well as the capital
required. A broker is a person who executes the trade on behalf of others, whereas
a dealer is a person who trades business on their own behalf. A dealer is a person
who will buy and sell securities on their account. On the other hand, a broker is
one who will buy and sell securities for their clients. When dealing with securities,
dealers make all decisions in respect of purchases. On the other hand, a broker will
only make purchases as per the clients wishes. While dealers have all the rights
and freedom regarding the buying and selling of securities, brokers seldom have
this freedom and these rights.
The broker is a completely independent player in over-the-counter (OTC) financial
or non financial markets. Its role primarily consists of providing a point of contact
for institutional clients seeking to buy or sell financial or non financial products.
Regulatory restraints require the broker to act as a pure intermediary, taking no
positions or dealing risks in the financial markets.
A dealer is defined by the fact that it acts as principal in trading for its own
account, as opposed to a broker who acts as an agent in executing orders on behalf
of its clients. A dealer is also distinct from a trader in that buying and selling
securities is part of its regular business, while a trader buys and sells securities for
his or her own account but not on a business basis.

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Broker Dealer

Executes customers orders Participates in the trade as a

Charges a commission
Charges a markup or markdown Page | 4
Must disclose the amount of the Makes a market in the security
Must disclose the fact that they are a
To ensure market liquidity and respond market maker, but not the amount of
rapidly to its clients' needs, the mark-up or markdown
To respect the confidential nature of its
An individual who issues or
clients' transactions. originates securities that he or she
also buys and sells

2.7- Variations in the Underwriting of Securities :

The procedure by which an underwriter brings a new security issue to
the investing public in an offering. In such a case, the underwriter will guarantee a
certain price for a certain number of securities to the party that is issuing the
security while the underwriter bears the risk of the issue.
In the insurance industry, underwriting is the process of agreeing to bear
the financial risk inherent in an insurance contract. The insurance underwriters
assess the risk that is being insured, for instance, fire damage to a house.
The word "underwriter" is said to have come from the practice of having each risk-
taker write his or her name under the total amount of risk that he or she was willing
to accept at a specified premium

Variations in the Underwriting Process :

Underwriting activities are regulated by the Securities and Exchange
Commission (SEC) under the SEC Act of 1933.
Bought Deal: In a bought deal, the underlying firm that buys the deal will have
presold most of the issue to institutional clients. Under Rule 415 (Shelf
Registration) underwriters may have to respond quickly to issuer needs. Bids must
be accepted quickly and thus require substantial capital commitments. Risks can
sometimes be mitigated, however, by pre-selling to clients.
Auction Process: Competitive bidding underwriting, sometimes mandated as in
the case of public utilities. The issuer then takes the bid with the lowest yield.
Presumable the price should be higher for the issue, but investment bankers
respond by saying that they have a larger client base and that they provide the
liquidity of a market maker. Therefore their costs should be lower.
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Pre-emptive Rights Offering: A corporation can issue new stocks to existing

shareholders. This is called a pre-emptive rights offering. But not all shares of an
issue may be sold by that means. To ensure the success of an offering, issuers often
enter into stand-by underwriting agreements with underwriters, who will buy the
unsubscribed shares. Page | 5

2.8- World Capital Markets Integration and Fund Raising Implications:

Financial integration is a phenomenon in which financial markets in neighboring,
regional or global economies are closely linked together.
Capital market integration, process by which capital markets are integrated with
one another rather than segmented, leading to a convergence of market risk and
price. The global integration of capital markets is at once a principal driver of
globalization and a hallmark of the increasingly globalized economy. Capital
markets are settings in which buyers and sellers of different kinds of capital foreign
currencies, corporate securities, government bonds, bank loans meet to negotiate
Fund Raising Implications:
#- An entity may seek funds outside its local capital market with the expectation of
doing so at a lower cost than if its funds are raised in its local capital market.
Whether lower costs are possible depends on the degree of integration of capital
#- In the former case, investors in one country are not permitted to invest in the
securities issued by an entity in another country. As a result, in a completely
segmented market, the required return on securities of comparable risk traded in
different capital markets throughout the world will be different even after adjusting
for taxes and foreign exchange rates.
#- An entity may be able to raise funds in the capital market of another country at a
cost that is lower than doing so in its local capital market

2.9- Motivation for Raising Funds outside of the Domestic Market:

A corporation may seek to raise funds outside of its domestic market for four
First, in some countries, large corporations seeking to raise a substantial amount of
funds may have no other choice but to obtain financing in either the foreign market
sector of another country or the Euromarket, because the fund-raising corporation's
domestic market is not fully developed enough to be able to satisfy its demand for
funds on globally competitive terms.

M.Azmat Awan MA Eco, MBA Banking & Finance, MS Islamic Banking & Finance CP2000 SIALKOT

The second reason is the opportunities for obtaining a reduced cost of funding
compared to that available in the domestic market. In the case of debt the cost will
reflect two factors:
(1)- the risk-free rate, which is accepted as the interest rate on a U.S. Treasury
security with the same maturity or some other low-risk . Page | 6
(2)- a spread to reflect the greater risks that investors perceive as being associated
with the issue or issuer.
The third reason to seek funds in foreign markets is a desire by corporate treasurers
to diversify their source of funding in order to reduce reliance on domestic
investors. In the case of equities, diversifying funding sources may encourage
foreign investors who have different perspectives of the future performance of the
Finally, a corporation may issue a security denominated in a foreign currency as
part of its overall foreign currency management. For example, consider a U.S.
corporation that plans to build a factory in a foreign country where the construction
costs will be denominated in the foreign currency. Also assume that the
corporation plans to sell the output of the factory in the same foreign country.
Therefore, the revenue will be denominated in the foreign currency.

2.10- Function of Secondary Markets:

Businesses and governments raise capital in primary markets, selling
stocks and bonds to investors and collecting the cash.
In secondary markets, investors buy and sell the stocks and bonds among
themselves. The issuer of the asset doesnt receive funds from the buyer.
Secondary Market is the market where, unlike the primary market, an investor
can buy a security directly from another investor in lieu of the issuer. It is also
referred as after market. The securities initially are issued in the primary market,
and then they enter into the secondary market. Secondary Market has an important
role to play behind the developments of an efficient capital market. Secondary
market connects investors favoritism for liquidity with the capital users wish of
using their capital for a longer period.
Provides regular information about the value of security.
Helps to observe prices of bonds and their interest rates.
Offers to investors liquidity for their assets.
Secondary markets bring together many interested parties.
It keeps the cost of transactions low.
The stock market offers attractive opportunities of investment in various
Companies can easily raise fresh capital from stock market

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Demand of supply of securities the stock exchange permits healthy

speculation of securities.

2.11- Trading Locations:

In a In making your own Trading allocations based on these specific expectations, Page | 7
people trade financial securities, commodities, and other fungible items of value
at low transaction and at prices that reflect supply and demand. Securities include
stocks and bonds, and commodities include precious metals or agricultural goods.
In economics, typically, the term market means the aggregate of possible buyers
and sellers of a certain good or service and the transactions between them. So
trading location of Investor in diversified securities is only possible with market
volume and nature of stocks available.

2.12- Market Structures:

A market can be defined as a group of firms willing and able to sell a similar
product or service to the same potential buyers. Market structure refers to the
number and size of buyers and sellers in the market for a good or service.

The financial markets can be divided into different subtypes:

1.Capital markets which consist of:

* Stock markets, which provide financing through the issuance of shares or
common stock, and enable the subsequent trading thereof.
* Bond markets, which provide financing through the issuance of Bonds, and
enable the subsequent trading thereof.
2.Commodity markets, which facilitate the trading of commodities.
3.Money markets, which provide short term debt financing and investment.
4. Derivatives markets, which provide instruments for the management of financial
*Futures markets, which provide standardized forward contracts for trading
products at some future date; see also forward market.
5.Insurance markets, which facilitate the redistribution of various risks.
6.Foreign exchange markets, which facilitate the trading of foreign exchange.

The capital markets consist of primary markets and secondary markets. Newly
formed (issued) securities are bought or sold in primary markets. Secondary
markets allow investors to sell securities that they hold or buy existing securities.

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In economics, market structure is the number of firms producing

identical products which are homogeneous.

Monopolistic competition, a type of imperfect competition such that many producers

sell products or services that are differentiated from one and hence are not perfect
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Oligopoly, in which a market is run by a small number of firms that together control the
majority of the market share.
Duopoly, a special case of an oligopoly with two firms.
Monopsony, when there is only a single buyer in a market.
Oligopsony, a market where many sellers can be present but meet only a few buyers.
Monopoly, where there is only one provider of a product or service.
Natural monopoly, a monopoly in which economies of scale cause efficiency to increase
continuously with the size of the firm. A firm is a natural monopoly if it is able to serve
the entire market demand at a lower cost than any combination of two or more smaller,
more specialized firms.
Perfect competition, a theoretical market structure that features no barriers to entry, an
unlimited number of producers and consumers, and a perfectly elastic demand curve.

2.13- Secondary Market Trading Mechanic

In the stock market, some of the terms and concepts of options trading mechanics
will be familiar. When you contact your broker to initiate a trade, youll encounter
the usual variety of choices market orders, limit orders, day orders, good-til-
canceled (GTC) orders, and so on. In most cases its an electronic entry in a share
registry, although in smaller markets overseas, it is still delivery of share

2.14- Market Efficiency

Market efficiency was developed in 1970 by Economist Eugene Fama who's
theory efficient market hypothesis (EMH), stated that it is not possible for an
investor to outperform the market because all available information is already built
into all stock prices.Pricing efficiency refers to a market where prices at all times
fully reflect all available information that is relevant to the valuation of securities
In defining the relevant information set that prices should reflect. Pricing
efficiency of a market was classified in three forms.
Weak efficiency
Semi-strong efficiency
Strong efficiency

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Weak efficiency : means that price of the security reflect the past price and trading
history of the securities. Keen investors looking for profitable companies can earn
profits by researching financial statements.
Semi-strong efficiency : means that the price of the security reflects all public
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information which includes but is not limited to historical price and trading
patterns. Meaning that neither fundamental nor technical analysis can be used to
achieve superior gains.
Strong efficiency: exists in a market where the price of security reflects all
information whether or not it is publicly available. So successful value investors
make their money by purchasing stocks when they are undervalued and selling
them when their price rises to meet or exceed their intrinsic worth.

2.15- Transaction Costs: The costs other than the money price that are incurred
in trading goods or services. Expenses incurred when buying or selling securities.
Transaction costs include brokers' commissions and spreads (the difference
between the price the dealer paid for a security and the price the buyer pays). The
transaction costs to buyers and sellers are the payments that banks
and brokers receive for their roles in these transactions. There are also transaction
costs in buying and selling real estate. These fees include the agent's commission
and closing costs such as title search fees, appraisal fees and government fees.
Transaction costs consist of commissions, fees, execution costs and opportunity
Commissions are the fees paid to brokers to trade securities.
Fees are separated two group custodial fees and transfer fees.
Custodial fees are fees charged by an institution that hold securities in
safekeeping for an investor.
Execution costs represent the difference between the execution price of a security
and the price that would have existed in the absence of the trade.
OPPORTUNITY COSTS: The cost of not transacting represents an opportunity
cost. It may arise when a desired trade fails to be executed. This component of
costs represents the difference in performance between an investors desired
investment and the same investors actual investment after adjusting for execution
costs, commissions and fees.
These are the main sorts of transaction costs, then: search and information
costs, bargaining and decision costs, and policing and enforcement costs.

M.Azmat Awan MA Eco, MBA Banking & Finance, MS Islamic Banking & Finance CP2000 SIALKOT