25556 Chap.4 Direct Financing in Primary and Secondary Markets
Direct Financing in Primary and Secondary Markets
Topic 2 follows money along the direct route, where a borrower sells securities to investors instead of taking a bank loan. The chapter starts with the firms that make this possible: investment banks on the issuer's side and fund managers on the saver's side.
It explains the four preference gaps both routes must bridge, and why the issuer always pays more than the investor finally keeps.
It then separates the primary market, where new securities are created through tenders, best-efforts offers, standby underwriting and credit ratings, from the secondary market, where existing securities change hands.
You will compare broker-run exchanges with dealer-run over-the-counter markets, read limit and at-market orders against an order book, distinguish a dealer's spread from the market spread, and see how liquidity and price discovery after issue make investors more willing to buy new securities.
What this chapter covers
- 01
Investment banks, fund managers and direct financing
- 02
Size, maturity, risk and return mismatches
- 03
The spread or cost of direct financing
- 04
Tenders, best efforts and standby underwriting
- 05
Exchange and over-the-counter trading arrangements
- 06
Liquidity and price discovery in secondary markets
Worked example · free
Size the underwriter's take-up and the net proceeds of a best-efforts share issue
- 1Issue value: 30,000,000 × $2.00 = $60m, which the underwriting contract guarantees will be raised.
- 1Applications: 23,500,000 × $2.00 = $47m, so the underwriter takes up the 6.5 million unsold shares, worth $13m.
- 1Fees: commission 0.015 × $60m = $0.9m plus the underwriting fee 0.02 × $60m = $1.2m, a total of $2.1m.
- 1Net proceeds: $60m − $2.1m = $57.9m. Without the standby contract the company would have raised only the $47m applied for, before fees.
Key terms
- Investment bank
- A securities firm that helps companies and governments issue securities, preparing documents and marketing the issue for a fee.
- Best efforts
- An issue arrangement where the bank markets the securities but does not promise that all of them will be sold.
- Standby underwriting
- A separate contract under which an underwriter agrees to buy any securities that investors do not take up.
- Limit order
- An instruction to trade only at a stated price or better: no higher when buying, no lower when selling.
- Market spread
- The gap between the highest bid and the lowest offer quoted across all dealers in a security.
Direct Financing in Primary and Secondary Markets FAQ
How does the primary market differ from the secondary market?
The primary market is where new securities are sold for the first time, so the issuer receives the money. The secondary market is where investors later trade those securities with each other; the issuer receives nothing from those trades, but an active secondary market makes investors more willing to buy the next issue.
Why is the cost of direct financing higher for the issuer than the return to investors?
The issuer pays interest or dividends plus fees to the investment bank that arranges the issue, while investors usually hold securities through fund managers whose fees are deducted from returns. The difference between what the borrower pays and what the saver keeps is the spread of direct financing.
What is the difference between a broker and a dealer?
A broker acts as an agent, placing clients' orders on an exchange and earning commission without owning the securities. A dealer acts as a principal, buying and selling for its own account, quoting bids and offers, holding an inventory and earning a trading spread while bearing price risk.
What happens to a limit order that does not trade immediately?
It stays in the exchange's central order book until it is either matched or cancelled. Because the book is visible, a waiting limit order shows other traders a price at which they can deal, which is part of what makes exchange markets transparent.
How do ratings agencies help investors in new debt issues?
They give an independent opinion on credit risk, condensed into a rating where a higher grade means lower risk. Debt is usually rated before it is offered, so the rating shapes demand and helps close the information gap between issuers and investors.
Exam move
Draw two columns headed primary and secondary, and list under each the people involved, who receives the money and what each charges. Practise placing a short scenario, such as a government tender or a crowdfunding raise, into the correct column within a few seconds. Rework the order-book idea with your own bid ladder, checking which bids a limit order can reach and which part is left waiting.
For dealer markets, write a set of four quotes and find both each dealer's spread and the market spread, so you can explain why the second is narrower. Finally, explain aloud how liquidity and price discovery after issue help the next issue succeed.
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