SECURITIES MARKETS The primary function of a securities market—whether or not it has a

SECURITIES MARKETS The primary function of a securities market—whether or not it has a

physical location—is to bring together buyers and sellers of securities. Securities markets can be classified by whether they are involved in orig- inal sales or resales of securities, and by whether or not they involve a physical trading location.

Primary and Secondary Markets When a security is first issued, it is sold in the primary market. This is

the market in which new issues are sold and new capital is raised. So it is the market whose sales directly benefit the issuer of the securities.

There are three ways to raise capital in the primary market. The first is the direct sale, in which the investor purchases, say, stock directly from the issuer. Many venture capital firms invest in small, growing businesses in this way. Also, many corporations sell securities directly to large investors, such as pension funds. By doing so, the issuer can tailor the features of the security (such as maturity) to suit the desires of the investor. This type of selling is referred to as private placement.

A second method is through financial institutions, which are firms that obtain money from investors in return for the institution’s securities and then invest that money. For example, a bank issues bank accounts in return for depositors’ money and then loans that money to a firm. Besides banks, firm such as mutual funds and pension funds operate as financial institutions.

2 U.S. General Accounting Office (GAO), Financial Derivatives: Actions Needed to Protect the Financial System, May 1994, p. 6.

FOUNDATIONS

EXHIBIT 2.1 The Three Methods of Raising Capital in the Primary Markets

Directly to investors

funds

Investors Firm

security

Through a financial institution

depositor account debt Investors

Firm deposited funds

Financial institution

funds

Through an investment banker

security security Investors

Firm funds

Investment banker

funds The third method for primary market transactions operates through

investment bankers, who buy the securities issued by corporations and then sell those securities to investors for a higher price. This process of buying shares from the issuer and reselling them to investors is called underwriting. For example, Kraft Foods’ 2001 offering of newly issued common shares was underwritten by a syndicate of 15 underwriters, including Credit Suisse First Boston, Salomon Smith Barney, Deutsche Banc Alexander Brown, and J. P. Morgan. The offering raised $8.7 bil- lion, with Kraft Foods receiving over $8.4 billion:

Per share

Total proceeds

Initial public offering price

$8,680,000,000 Underwriting discount

$237,181,000 Proceeds, before expenses, to Kraft

$30.1529 $8,442,819,000 The three methods of raising capital in the primary market are illus-

trated in Exhibit 2.1. We discuss the underwriting of securities and the role of investment bankers in the next chapter.

A secondary market is one in which securities are resold among investors. No new capital is raised and the issuer of the security does not benefit directly from the sale. Trading takes place among investors. Investors who buy and sell securities on the secondary markets may

Securities and Markets

obtain the services of stock brokers, individuals who buy or sell securi- ties for their clients.

We can use the market for college textbooks to illustrate the differ- ence between primary and secondary markets. Suppose one of your instructors decides to use this book, Financial Management and Analysis, as the class text. The instructor notifies the school bookstore, which buys copies of the text from the publisher, John Wiley & Sons, and then puts them up for sale at a somewhat higher price than was paid. You then buy your new copy of this book from the bookstore. The market for new books, in which you, the publisher, and the bookstore have operated as buyer, seller, and intermediary, respectively, is a primary market. The bookstore has acted as a sort of textbook “investment banker,” but most of the money invested in the book has gone to the issuer (the publisher). The bookstore received a profit for performing as an intermediary, a facil- itator of the transaction between you and the publisher. The publisher would have been hard put to sell to each member of the class individually.

At the end of the term you may wish to sell your used copy of Financial Management and Analysis. You can sell it directly to a friend who is about to take the course, or you can sell it back to the bookstore for resale to another student. Both these transactions take place in the secondary text- book market, because the publisher (the issuer) is not a party to them.

If a firm can raise new funds only through the primary market, why should financial managers be concerned about the secondary market on which the firm’s securities trade? Because investors may not be inter- ested in buying securities that are not liquid—that they could not sell at

a fair price at any time. And the secondary markets provide the liquid- ity. For example, suppose IBM wants to issue new common shares to pay for its expansion program; investors would not be willing to buy such shares if they could not expect to sell them on the secondary mar- ket should the need arise. IBM counts on the existence of a healthy sec- ondary market to entice investors to buy its new stock issue.