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Investment: Primary and Secondary Markets

Abstract

The financial market comprises an important determinant in the economic performance of a country. Investors and institutions are increasingly appreciating the importance of the financial markets in attaining their economic goals. The financial markets are categorised into diverse subcategories. Some of the common subcategories include the secondary and primary markets. On the other hand, the secondary markets provide individuals with the opportunity to invest in different stocks, hence maximising their returns. This paper assesses the working of the financial markets. The study explains the nature of products offered in the two markets. Additionally, it also illustrates the differences with reference to stock performance in the two markets. Thus, the study illustrates some of the critical aspects that individuals and institutions should consider in making the decision to invest in securities through the financial markets.

Introduction

Pathak (2007) contends that financial and real assets form the foundation of a country’s economy. The financial system constitutes a vital component of a country’s economy due to its financial intermediation role. The financial system acts as a link between the deficit and the surplus unit of an economy. The deficit unit relates to the planned and consumption that is over the available income. Thus, the deficit unit is characterised by shortage or negative saving. Conversely, the surplus unit acts as a source of ‘loanable’ funds.

According to Bank of England (2008), financial markets have become a global phenomenon. Moreover, the Bank of England (2008) emphasises that the significance of the financial market is considerably high in capital-scarce developing countries despite the existence of market contagion and risk. Financial markets are characterised by a high degree of risk. Thus, the volatility in a particular market segment can quickly spread through the entire market. Redhead (2008) further emphasises that the financial system promotes mobilisation and allocation of scarce resources in an economy. Madura (2014, p. 89) affirms that the ‘financial system is complex and it is comprised of a set of well-integrated subsystems’. The sub-systems include financial instruments, markets, services, and institutions. The financial markets promote value creation and business growth through its primary and secondary market functions. The financial markets can be categorised into two main segments, which include the primary and secondary market segments. Williams (2011, p.653) corroborates that the ‘financial market facilitates the pricing and diversification of risk, aid in the price-discovery process of financial assets, and enhance the domestic financial system’.

The two market segments differ with reference to the nature of their operations. Additionally, the two market categorisations include the primary and secondary markets. The primary market segment mainly specialises in new issues. Thus, the primary market segment entails companies or institutions intending to issue financial security to the public such as stocks and bonds for the first time. Conversely, the secondary market segment involves trading in existing or outstanding securities. Burton, Nesiba, and Brown (2015) cite the convenience and cost involved in trading in existing securities as the core determinants of the quality of the secondary market. Furthermore Burton, Nesiba, and Brown (2015, p. 47) opine that in ‘high-quality secondary markets, securities are traded at relatively at relatively low cost and little inconvenience’. This aspect means that securities change hand within the shortest time possible. These characteristics play a fundamental role in promoting smooth flow and efficient allocation of financial resources. The existence of the secondary market promotes continuous interaction between the demand and supply units in the financial market. Therefore, the financial markets promote the optimal utilisation of long-term investment.

Despite the fact that the secondary market segment does not lead to the generation of new funds, its efficient operation is a fundamental determinant of the primary market segment growth. This aspect underscores the existence of a strong correlation between the primary and secondary market segments. Redhead (2008) argues that the price of financial instruments in the secondary market influences the price at the primary segment. This aspect is well illustrated by the view that entities intending to source long-term capital from the stock market benchmark the price of their securities using the historical price of other companies operating in the same industry listed in the stock exchange market. This research paper explores the working of the financial market. The paper explains how the primary and secondary markets operate coupled with the nature of the products available in the two market segments.

Literature review

Analysis of the financial markets

Madura (2014) emphasises that the primary and secondary market segments differ considerably with reference to the nature of transactions undertaken. Madura (2014) further cites liquidity as one of the fundamental characteristics of the secondary markets. Therefore, securities traded in the secondary market should be easily disposed without losing value. Investors assess the degree of liquidity associated with certain securities before making the decision to include certain stocks in their investment portfolio. The degree of liquidity associated with the securities determine their attractiveness to investors, hence the ease of disposal (Madura 2014).

The primary market

According to Williams (2011), the primary market specialises in raising new capital. Thus, organisations can successfully raise long-term capital to be committed to long-term investments by issuing securities in the primary market segment. Organisations can use different methods in raising capital through the primary market. The primary market is undergoing remarkable transformation due to the developments in the market. One of the factors that have led to the market developments entails the recognition of the primary market as an effective source of long-term capital. Currently, the market is categorised into six basic types through which businesses can use in raising capital. Below is an analysis of the core primary market methods.

Underwriting

Underwriting is one of the most common methods used by organisations in raising capital. Williams (2011, p.79) asserts that underwritings ‘are typically used for corporate securities, particularly equities and some bonds’. Williams (2011) further accentuates that underwriting is an obligatory task that organisations intending to raise capital from the public must undertake. Underwriting enables organisations to undertake initial public offers successfully with reference to their securities. This goal is achieved by the underwriter in collaboration with stockbrokers and investment bank purchasing the securities and reselling them in the primary market. The underwriters in the primary market guarantee companies undertaking the IPOs public subscription for their securities for a commission. In the event of the IPO failing to dispose the securities at the predetermined price, the underwriter bears the cost. This aspect underscores the fact that the underwriters bear a significant risk in their underwriting process.

The stockbrokers and investment banks engaged in underwriting must comply with the statutory requirement. For example, stockbrokers should not underwrite over 5% of the public issue by a particular organisation. Conversely, investment banks have an opportunity to underwrite up to 10% of the total public issue. In the course of making a decision on the underwriter to use in the public market, it is imperative for businesses to consider a number of factors. The critical factors include the reputation of the underwriter, financial capacity, outstanding underwriting commitments, and the effectiveness with which the investor has established an effective network of investor clientele.

The underwriter has the obligation to define the chosen instrument to be issued in the stock market. The underwriter’s mandate also entails determining and setting the initial price of the security. Moreover, the underwriter has the obligation to determine the most appropriate time to launch the IPO. In the course of issuing new securities, it is imperative for the underwriter to define the prospected risks and benefits associated with the securities. Provision of such information gives potential investors an opportunity to effective investment decisions.

Shelf registration

This method is used in the primary markets in an effort to minimise the cost associated with issuing new securities. Williams (2011) contends that the concept of shelf registration increases flexibility and smooth operation of the primary market. Under this method, companies intending to issue new securities are provided with a 2-year window, within which they can issue their securities. Therefore, organisations have the discretion to determine the most appropriate time to issue security to potential investors. Therefore, the shelf registration method offers organisations an opportunity to raise capital from the public when it is most required. Additionally, an organisation’s management team can decide to issue securities when the market is most receptive.

The application of the shelf registration method has also played a fundamental role in reducing the underwriting fees. Under the concept of shelf registration, organisations have the discretion of raising finance from the public through the private placement (Dresner & Kim 2006). Moreover, organisations can exploit the advantages of shelf registration by filing the shelf registration statement. Thus, an organisation can shelf as many securities as possible in accordance with the amount of capital it intends to raise within a specific time. Some of the securities that can be filed in the primary shelf registration include preferred stock, common stocks, debt instruments, and warrants.

Direct placement

This method of raising capital in the primary market entails issuing securities directly to investors without using the services of an agent or stockbroker. Under this method, an organisation identifies a small number of potential investors to whom it intends to sell its stock. This assertion means that the direct placement method is mainly a personal approach to raising capital from the primary market as opposed to the public offering.

Auction

Auctions are a common method of operations in the primary market segment. Under this method, the institutions intending to sell their securities in the stock market congregate in a specific area where they meet with the willing buyer. The seller announces the bid and asks for price of their securities. During the public auctions, the institutions issuing the securities focus on minimising the cost of issuing securities. Thus, public auctions are based on a bidding process.

Syndicated loans

Some organisations may be unable to raise financial capital from the stock market through the normal underwriting or auction method. However, the primary market provides such organisation with an opportunity to raise finance to be used in long-term projects. In this method, the lead bank establishes relationships with other banks and shares the loan amount. Currently, banks are increasingly approaching the primary market in an effort to diversify risk. Syndicated loans enable financial institutions to avoid the risk associated with extending credit facilities to a single large borrower (Williams 2011). The syndicate banks have the discretion to resell the syndicated loans to other investors or wait until its maturity.

Secondary market

Operations within the secondary market mainly involve trading amongst investors. Brakman (2006) corroborates that the secondary markets promote liquidity in the financial markets. The secondary markets play a fundamental role in determining price volatility and market efficiency. Organisations or entities intending to issue securities through IPOs determine the price of their securities based on comparable stocks traded in the secondary market. Moreover, Brakman (2006, p.101) affirms that new issues of ‘outstanding stocks or bonds to be sold in the primary market are based on prices and yields in the secondary market’.

The secondary markets are characterised by two main market structures, which include the quote-driven market structure and the order-driven market structure. In the order-driven market structure, the investors [buyers and sellers] bid for certain securities, which are submitted through the stockbrokers. All the bids are collected in a central position and compared during the process of executing the transaction (Fabozzi & Drake 2009). Alternatively, the order-driven market structure can also be defined as the auction market. On the other hand, the quote-driven market structure is characterised by dealers or market makers who determine the price of securities on behalf of the public participants. According to Fabozzi and Drake (2009, p.128), ‘market makers provide a bid quote and an offer quote and realise revenues from the spread between the two quotes’.

The structure of the secondary market is also comprised of the over-the-counter and exchange markets. Fabozzi and Drake (2009) define the exchange as the central trading locations whereby different financial instruments are traded. However, the instruments must adhere to all the requirements stipulated by the stock market. Conversely, operations within the over-the-counter secondary market mainly involve trading in securities that are not listed in the stock market.

In addition to the above aspects, the secondary market is also organised into the principal and agency market. The agency markets establish a link between the demand and surplus units, hence facilitating the development of the secondary market. Fabozzi and Drake (2009, p.287) further assert that the ‘secondary market agency buys a large number of mortgage loans from primary market lenders and then issues securities using the loans as collateral’. There are a number of well-established secondary market agencies such as Ginnie Mae, Fannie Mae, Farmer Mac, and Freddie Mac.

The secondary market agencies give private investors mortgage-backed securities. The loan repaid by borrowers is transferred to investors. The secondary market agents act as guarantors, which mean that they shield the investors from the risk of default on the underlying loans. However, to minimise the risk of default, the agents are required to adhere to uniform underwriting standards. The other components of the secondary market include the principal market, which provides investors with an opportunity to purchase securities directly from the seller.

Financial market instruments

The primary and secondary market is characterised by diverse instruments.

Primary market instruments

Some of the common primary market instruments include bonds and stocks or shares. The bonds refer to securities that are issued in the primary market and have a substantially long maturity period. Investors receive a predetermined return on investment by purchasing the bond. On the other hand, common stocks or shares do not have a maturity period. On the contrary, they provide investors with ownership of the entity. However, investors may dispose the shared ownership in the secondary market.

Secondary market instruments

The secondary market instruments are categorised into three main segments, which include the variable income, fixed income instruments or bonds, and the hybrid income instruments. The fixed income securities refer to financial instruments that are characterised by a predetermined payment schedule. Bonds are some of the common fixed income securities. Therefore, the bonds have a specified period within which the associated interest and principal should be paid. The corporate bonds are some of the most common fixed income instruments. The corporate bonds assure investors of periodic repayment on the principal amount plus the interest. The corporate bonds may be secured or unsecured (debentures). The secured bonds are backed by specific collateral. The issuing company can recall corporate bonds. However, the recalling price is usually high. Other fixed income instruments in the secondary market include the preferred stock and the mortgage-backed securities. The holders of preferred stock are subject to periodic payments or dividends (Gwartney et al. 2012). The equity gives investors an opportunity to be shareholders in a particular organisation. On the other hand, the hybrid income instrument includes the convertible preferential shares and mutual funds. The convertible preferential shares provide investors an opportunity to convert them into common shares.

Methodology

This study is based on mixed research design. The design has been implemented by integrating the exploratory literature review design. Subsequently, an in-depth review of past studies on primary and secondary studies is undertaken. Moreover, the study has also employed qualitative research design by incorporating the focus group interviews. The interviews are conducted on a number of market participants in order to develop a comprehensive understanding of the financial market. A sample of 25 respondents was selected from 10 organisations in the US. The organisations considered include firms that are newly listed on the New York Stock Exchange. The researcher selected respondents who were fully conversant with operations in the primary and secondary market. The financial data collected was processed and presented using financial data analysis procedures that include graphs and tables. The data collected in studying the financial markets include financial ratios involving the evaluation of different market and corporate performances. Methods that involve examining time-series variations, comparison of financial data, and common stock characteristics have also been adopted. Furthermore, the research study has also integrated the regression- discontinuity design in an effort to investigate variation in the financial market through evaluation of both primary and secondary markets. This goal is achieved by incorporating the Russell 2000 and Russell 1000 indices. The researcher assumes that the stocks under the Russell 1000 represents securities in the primary market and those in the Russell 2000 represent stocks in the secondary market. The choice of this methodology is informed by the need to provide investors with adequate information on the operations in the primary and secondary market and the role of the financial markets in enhancing business success.

Results and discussion

The exploratory literature review shows the existence of a strong correlation between the primary and secondary market. A time series study conducted based on the Russell 2000 index for stocks traded between 1996 and 2012 in the US indicates that the performance of stocks changes considerably after the addition of the trading index. Stocks that were initially ranked in the Russell 1000 and later moved up to the Russell 2000, due to increment in their market capitalisation within the period under consideration [1996-2012] were characterised by a discontinuously higher return in subsequent months from May 2005 as compared to stocks that missed inclusion into the Russell 2000 index.

An analysis of stocks within a 100 bandwidth from the cut-off had a t-statistic of 2.65. Therefore, the jump in the price of the stock was economically and statistically significant. This aspect illustrates that the price of the stock can improve considerably after the inclusion into the secondary market. However, 58% of the respondents interviewed were of the opinion that significant price changes are likely to occur in months immediately after addition into the stock market. Thus, the price of stocks might change in subsequent years. The respondents were of the opinion that the price changes are likely to occur due to economic changes, viz. the demand and supply forces.

In order to protect the price of their securities from fluctuating, 65% of the respondents interviewed were of the opinion that it is imperative for organisations to consider integrating the concept of benchmarking. The respondents were of the view that organisations should identify the most appropriate index to benchmark. Benchmarking aids in tracking the volatility of the stock prices to market changes. Furthermore, the respondents were of the opinion that it is imperative for organisations to consider increasing their market capitalisation in order to improve the attractiveness of their stocks to potential investors. The respondents’ assertion is supported by findings of past studies based on the Russell Indexes. The study involving firms trading in the Russell 1000 and Russell 2000 depicts the existence of a significant difference in the performance of the company’s stocks.

The stocks of firms within the Russell 2000 category had higher returns as compared to stocks in the Russell 1000. Additionally, the market capitalisation for companies trading in the Russell 1000 index was estimated to be US$ 4.22 billion, while that of firms in the Russell 2000 stocks was estimated to be US$ 0.5 billion. This aspect highlights the fact that improving the volume of stocks trading in the stock market increases the likelihood of a firm bettering its financial performance. Furthermore, newly added shares in the primary market are more likely to attract investors as compared to existing firms in the stock market. This assertion is further affirmed by the difference in the degree of liquidity between the stocks traded under the two indices. The level of illiquidity is considerably higher for stocks under the Russell 2000, as compared to stocks in the Russell 1000 index.

Table 1 and graph 1 below illustrate the performance of stocks in under the Russell 1000 [primary market] and the Russell 2000 [secondary]. The performance is evaluated based on the different financial ratios such as the earning per share [EPS], Return on Assets [ROA], monthly stock return [RET], illiquidity [ILLIQ], correlation [CORR], short interest ratio [SR], issuance [ISSUANCE], or the proportion of stocks compared to the initial shares.

Table 1

Performance metric Russell 1000 Russell 2000
RET 0.007 0.007
MKTCAP 4.22 0.516
ILLIQ 0.053 1.02
ISSUANCE 0.014 0.024
SR 0.023 0.033
ROE 0.133 0.093
ROA 0.046 0.035
EPS 1.69 0.84
CORR 0.475 0.466
Comprasion of stock
Graph 1

Table 1 above shows the existence of significant differences between the performances of stocks in the primary market [Russell 1000] and the secondary market [Russell 2000]. One of the most notable differences relates to market capitalisation, earning per share, and return on equity. In an effort to understand the cause of the difference in the performance of stocks in the two markets, the researcher asked the respondents in the focus group the possible cause of such differences. In their opinion, 76% of the respondent were of the opinion that stocks issued in the primary market are expected to attain a positive performance because of their attractiveness to investors. However, the analysis shows that the performance of the stocks in the primary and secondary markets is strongly correlated. The degree of correlation in the primary market is estimated to be 0.475 while that in the secondary market is estimated to be 0.466.

The differences in the performance of stocks in the two markets underscore the importance of establishing an efficient stock market. This move will ensure the free flow of funds, hence improving the attractiveness of stocks in the secondary market to potential investors is relatively low. The performance of the stocks in the primary market segments is strongly correlated with that of the secondary market. However, it is critical for organisations to focus on improving the degree of liquidity in the secondary market. This move will enhance the future performance of the stocks.

Reflection

The above analysis shows that organisations can adopt different methods in raising capital from the primary market. Some of the methods adopted in the primary methods include the direct placement method, shelf registration, underwriting, syndicated loans, and auctions. In the course of making decisions to enter the primary market, it is imperative for organisations to undertake a cost-benefit analysis in order to determine the most effective strategy. For example, using the direct placement method improves an organisation’s capacity to minimise the cost of raising capital from the primary market.

The analysis above further highlights the significance of entrenching a high level of efficiency in both the primary and secondary markets. One of the most notable hindrances to operations in the secondary and primary market relates to the existence of stock illiquidity. Most investors base their decision to incorporate certain stocks within their investment portfolio based on the information offered by the primary and stock market. In a bid to improve the quality of the decision, stock markets should be characterised by a high degree of information efficiency. This aspect will play a fundamental role in minimising the occurrence of insider trading by some players (Zoan 2014). Therefore, the agents in the stock market should communicate information to investors in order to improve their decision-making capacity.

Conclusion

The stock market constitutes a fundamental component in the economic growth of a country. The primary and secondary markets establish a link between the deficit and surplus units. Thus, the markets promote investment and distribution of wealth in different sectors. The primary markets provide entities [governments or businesses] with an opportunity to raise long-term capital by issuing diverse securities such as bonds and shares. Therefore, different entities are able to undertake long-term capital projects. Conversely, the secondary market creates an opportunity for investors and businesses to increase returns by facilitating continuous trade after the initial offer. The paper further illustrates that the performance of stocks in the secondary market is strongly correlated with the performance of the primary market. Therefore, it is imperative for governments to focus on developing a strong level of market efficiency. One of the critical issues that should be focused on entails free flow of information within the stock market. Additionally, it is imperative for governments through the capital market authorities to eliminate unfair trading practices such as insider trading. This move will play a fundamental role in improving the effectiveness of the primary and secondary markets in contributing to the country’s economic performance.

Reference List

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