Financial Markets

What is a Market?

A market is a public place where products or services are sold, either directly or through intermediaries. Markets are important for a number of reasons:

They provide a place (either physical or virtual) for the trading of goods or services. They provide for competition so that the best price may be found (this is called price discovery). They provide liquidity.

Money vs. Capital Markets

Money Market Short-term, high quality debt securities are traded here. These securities carry little or no default risk and have very little price risk due to their short maturities. Capital Market Long-term securities trade in the capital markets. These securities are subject to significant price risk, default risk, purchasing power risk, etc. due to their longer maturities.

Primary vs. Secondary Markets

Primary markets are where securities are initially sold. In this market the issuer receives the proceeds from the sale. Once securities have been sold into the primary market, they begin trading in the secondary markets. In the secondary markets the seller of the securities receives the proceeds, not the issuer. Primary markets would barely exist were it not for well functioning, efficient secondary markets. At the least, prices of securities would be far lower due to much higher required returns. How much would you pay for a security that you could never sell? There are also third and fourth markets. The third market is comprised of trades in listed securities away from the exchange where they are listed. This is an institutional market. The fourth market refers to trades directly between buyers and sellers.

Organized vs. OTC Markets

Organized markets are those which have a physical location where all trading takes place. For example, the NYSE, Amex, and regional exchanges are organized markets. Over the Counter (OTC) markets do not have physical locations. Instead, they are characterized by networks of dealers who are connected by telephone or computer networks. The Nasdaq is an example of an OTC market.

Investment Bankers

When securities are sold into the primary market, firms enlist the services of investment bankers. Investment bankers provide three basic services to companies:

Advice and counsel (before and after the sale) Underwriting Distribution

Investment Banking Functions: Advice and Counsel

Investment bankers provide important advice on security issues, such as:

Pricing Size of the offering Timing of the offering Type of security (debt or equity) Special features (callability, convertibility, coupon rate, etc)

Additionally, investment bankers often consult on issues of corporate governance, such as mergers.

Investment Banking Functions: Underwriting

Once the company and investment banker agree as to the type of security, pricing, etc. the issue is ready to market. The investment banker may either:

Underwrite the issue here the investment banker purchases the issue and hopes to sell it at a higher price to the public (assumes price risk). This is also known as a firm commitment. Act as an agent Also known as a best efforts offering, the investment banker does not purchase the securities and merely markets them to the public.

Typically only small, relatively unknown firms agree to a best efforts offering.

Investment Banking Functions: Distribution

The final role of the investment banker is to actually sell the securities. Typically, the originating investment banking firm will form an underwriting group (syndicate) to spread the price risk. Next, a selling group consisting of the underwriting group and, perhaps, other brokerage firms is formed to sell the security. Each member of the selling group is given an allocation for which it is responsible. The selling group then allocates its share of the securities among interested customers.

Investment Banking Functions: Distribution (cont.)

Before a new issue may actually be sold to investors, the originating underwriter must file a registration statement (Form S-1, or other Form S-x) with the Securities and Exchange Commission (SEC). This preliminary prospectus (red herring) contains information about the firm, the type of security being offered, and the proposed use of the proceeds. While it is being reviewed by the SEC, the preliminary prospectus is distributed to interested investors. The exact pricing, and often quantity, of the issue is determined the night before the actual offering. It is important to note that the SEC does not judge the quality of the issue and does not give investment advice. Its approval simply means that the prospectus meets all requirements concerning disclosure. For some time after the securities are sold, the investment banker will often participate in price-stabilizing trades (if the market tries to drive the price down, the IB will often step in to buy, thereby propping up the price).