FIN521 Chap.4 How Securities Are Traded
How Securities Are Traded
Two markets, and only one of them funds the company
A firm needing capital can borrow or sell part of itself. When it sells shares to the public for the first time, that happens in the primary market and the money reaches the company. Everything afterwards happens in the secondary market, where existing securities change hands between investors and the company receives nothing.
That distinction sounds pedantic until a news story reports that a founder selling shares has raised capital for the business, which is simply false.
It also explains what a listing really buys: shares in a listed firm trade continuously at a visible price, while shares in a private one are illiquid and require a specific buyer to be found and negotiated with.
Underwriting, and where the risk sits
Public offerings of shares and bonds are marketed by underwriters who advise the issuer on the terms of sale.
Under a firm commitment the underwriter buys the issue and resells it, so the bank carries the price risk. Under a best efforts arrangement the bank only agrees to try, and the risk stays with the issuer.
The advice is not disinterested, because the bank must also place the stock with clients it will need again, which is the agency problem of the first chapter reappearing with a second principal rather than a villain.
Underpricing, measured two ways
New issues are commonly priced below what the market would have paid.
The percentage measure is the first-day gap over the offer price, and it says how badly the price was set. The dollar measure is that gap multiplied by the shares sold, and it says what the mispricing cost. Only the second scales with the size of the issue.
The important reading is about who bears what: under a firm commitment the bank bore the downside risk, while the cost of a first-day jump falls on the company and its existing owners, who could have raised that much more for the same dilution.
A first-day jump is therefore evidence about who captured value, not that the listing went well.
Orders and the cost of using them
In a dealer market the bid is what a dealer will pay and the ask is what a dealer will sell at, and the spread between them is a cost paid on entry and again on exit without ever being invoiced. A market order buys immediacy and accepts whatever price the book offers.
A limit order specifies the price and accepts that it may never execute. Neither is cautious or reckless in itself; each encodes a belief about whether the current price is close to fair.
Costs come in two kinds, and only the explicit brokerage commission appears on a statement; the spread and the price concession paid on orders larger than the posted quote are implicit and decide whether a strategy that looks profitable on paper survives contact with the market.
What this chapter covers
- 01
Primary against secondary markets, and who receives the money
- 02
Liquidity as the thing a listing actually buys
- 03
Initial public offerings against seasoned equity offerings
- 04
Firm commitment against best efforts underwriting
- 05
The advantages and costs of going public
- 06
Underpricing and money left on the table, and who bears each
- 07
Bid and ask prices in a dealer market
- 08
Market orders against limit buy and limit sell orders
- 09
Explicit commissions against implicit spread and price concession
Decide which order to place, and price the decision
- 3Name the order each investor should place and the belief it encodes.
- 3Compute the implicit cost A pays on a round trip at the quoted spread.
- 2State what B gives up and under what condition it turns out badly.
Key terms
- Primary Market
- The market in which new securities are first offered to investors, and the only one in which the issuing company receives the proceeds.
- Secondary Market
- The market in which existing securities trade between investors, so that a sale changes ownership without funding the company.
- Initial Public Offering
- A private firm's first sale of shares to the public, normally marketed by underwriters who advise on the terms of sale.
- Seasoned Equity Offering
- A sale of additional shares by a company already listed, which raises new capital and dilutes existing holders.
- Firm Commitment
- An underwriting arrangement in which the bank buys the whole issue and resells it, so the bank rather than the issuer bears the price risk.
- Money Left On The Table
- The first-day gap between offer price and closing price multiplied by the shares sold, which is what the issuer and its owners forwent.
- Market Order
- An instruction to trade immediately at whatever price the book currently offers, buying certainty of execution at the cost of price certainty.
- Limit Order
- An instruction to trade only at or better than a stated price, buying price certainty at the cost of possibly never executing.
- Price Concession
- The implicit cost of trading in a size larger than the posted quote supports, as the order works through the book at worsening prices.
How Securities Are Traded FAQ
Does a first-day price jump mean the listing was a success?
It means the offer price was below what buyers would pay, which is a statement about the pricing rather than about the company. The company and its existing shareholders raised less than they could have, by exactly the money left on the table, and the gain went to whoever was allocated stock at the offer.
Whether the listing was a success is a separate question answered by what the price did over the following year or five, and confusing the two is the most common error in commentary on new issues.
Why would a company accept the costs of listing?
For access to new equity capital that funds expansion or acquisition, for a market in which private shareholders can realise their stakes, and for the credibility and recognition a listing brings with customers. Against that sit continuing disclosure obligations, exposure to pressure for short-term results, loss of some management control and operating freedom, and the underpricing typical of a first issue.
The decision is a trade rather than a milestone, and an answer that lists only one side has answered half the question.
When is a limit order the wrong choice?
When your own analysis says the current price is close to fair. In that case the limit order saves the spread and risks the position, and the position is worth more than the spread if the analysis was right. Limit orders belong where you have a specific view that the market price is wrong by a stated amount, which is exactly what the question will have told you if it wants that answer.
Framing the choice as caution against recklessness misses what is being tested.
Exam move
Practise converting a quoted spread into a percentage of the price, because the habit turns an abstract cost into a number you can compare with an expected return. Then take any new listing reported in the past year, compute the underpricing and the money left on the table from the offer price and the first close, and write one sentence on who captured that value.
Two worked examples are enough to make the distinction between the percentage measure and the dollar measure automatic.
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