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Another variation for the issuance of securities is the auction process. In this method,
the issuer announces the terms of the issue and interested parties submit bids for the entire
issue. The auction form is mandated from certain securities of regulated public utilities and
may municipal debt obligations. It is commonly referred to as a competitive bidding
underwriting. For example, suppose that a public utility wishes to issue $200 million of
bonds. Various underwriters will form syndicates and bid on the issue. The syndicate that
bids the lowest yield (i.e., the lowest cost to the issuer) wins the entre $200 million bind issue
and then reoffers it to the public.
In a variant of the process, the bidders indicate the price they are willing to pay and
the amount they are willing to buy. The security is then allocated o bidders on the basis if
the highest bid price (lowest yield in the case of a bond) to lower bid prices (higher yield bids
in the case of a bond) until the entire issue is allocated. For example, suppose that an issuer
is offering $500 million of a bond issue, and nine bidders submitted the following yields bids.

Bidder Amount ($ millions) Bid

A $150 5.1%
B 110 5.2
C 90 5.2
D 100 5.3
E 75 5.4
F 25 5.4
G 80 5.5
H 70 5.6
I 85 5.7

Bidders A, B, C, and D will be allocated the amount of the issue for which they bid
because they submitted the lowest yield bid. In total, they will receive $450 million of the
$500 million to be issued. That leaves $50 million to be allocated to the next lowest bidders.
Both E and F submitted the next lowest yield bid, 5.4%. In the total, they bid for $100 million.
Because the total they bid for exceeds the $50 million remaining to be allocated, they will
receive an amount proportionate to the amount or which they bid. Specifically, E will be
allocated three quarters ($75 million divided by $100 million) of the $50million, or $37.5
million; and F will be allocated one quarter ($25 million divided by $100 million, or $12.5
The next question is the yield that all old of the six winning bidders will have to pay for
the amount of the issue allocated to them. One way in which a competitive bidding can occur
is all bidders pay the highest willing yield bid (or, equivalently, he lowest winning price) in
our example, all bidders would buy the amount allocated to them at 5.4%. This type of
auction is referred at as a single price auction or a Dutch Auction. Another way is for each
bidder to pay whatever they bid. This type of auction is called a multiple-price auction.
Although the U.S. Department of the treasury currently issues securities using only a single-
price auction were used.
Using an auction allows corporate issuers to place newly sided securities (debt and
equity) directly with institutional investors rather than follow the traditional underwriting
process. For the example, Google Inc. used a Dutch auction to raise $2.7 billion in its IPO in
August 2007.
Investments bankers response to the practice of direct purchase of publicly registered
securities is that, as intermediaries, they add value by searching their institutional investors,
investment bankers argue, issuers cannot be sure of obtaining funds at the lowest cost. In
addition, investment bankers say they often play another important role. They make
secondary market in the securities they issue. This market improves the perceived liquidity
of the issue and. As a result, reduce the cost to issuers. Whether investments bankers can
obtain lower-cost funding (after accounting for underwriting fees) for the issuers, by
comparison to the cost of funding from a direct offering, remains an interesting empirical
question. However, an IPO issued via an auction can be utilized in conjunction with the
underwriting by investment bankers. For example, in the IPO for google.inc that used a Dutch
auction, the offering was underwritten by Morgan Stanley and Credit Suisse First Bond.


A corporate can issue new common stock directly to existing shareholders via a
preemptive right offering. A preemptive right grants existing shareholders the right to buy
some proportion of the new shares issued at a price below market value. The price at which
new shares can be purchased is called the subscription price. A rights offering insures that
current shareholders ay maintain their proportionate equity interest in the corporation. In
the united states, the practice of issuing common stick via a preemptive rights offering in
uncommon. In other countries it is much more common; in some countries, it is the only
means by which a new offering of common stock may be sold.
Or the shares skid via preemptive rights offering, the underwriting services of an
investment banker are not needed, however, the issuing corporation may use the services of
an investment banker for the distribution f common stick that is not subscribed to. A standby
underwriting arrangement will be used un such instances, this arrangement calls for the
underwriter to buy the unsubscribed shares. The issuing corporation says a standby fee to
the investment banking firm.

World Capital markets integration and Fun-Raising Implications

An entity may seek funds outside its local capital market with the expectation of doing so at
a lower cost that if its funds are raised in its local capital market. At the two extremes, the
world capital markets can be classified as either completely segmented or completely
In the former case, inventors in one country are not permitted to invest in the securities
by an entity in another country. As a result, in a completely segmented market. The
required return on securities of comparable risk traded in different capital markets
throughout the world will be different even after adjusting for taxes and foreign exchange
rates. An entity may be able to raise funds in the capital market f another country at a cost
that is lower than doing so in its local capital market.
At the other extreme, a completely integrated market contains no restriction to prevent
investors from investing in securities issued in any capital market throughout the world. In
such an ideal world capital market, the required return on securities f comparable risk will
be the same in al capital markets after adjusting for taxes and foreign exchange rates. This
situation implies that the cost of funds will be the same regardless of where in the capital
markets throughout the world the world fund-seeking entity elects to raise funds.
Real-world capital markets are neither completely segmented nor completely integrated
but fall somewhere in between. A mildly segmented market or mildly integrated market
implies that world capital markets offer opportunities to raise funds at a lower cost outside
the local capital market.
It is important to emphasize that were talking about capital markets in general rather
than markets for different instruments. More specifically the degree of integration differs
between equity (common stock) markets an debt marks. In Chapter 13 we will discuss the
evidence on the degree of integration of equity markets.
Motivation for Raising Funds Outside of the Domestics Market
A corporation may seek to raise funds outside of it domestic market for four reasons. First,
in some countries, large corporations seeking to raise a substantia amount of funds may
have no their choice but to obtain financing in either the foreign market sector of another
country or Euromarkets, because the fund-raising corporations domestic market is not fully
developed enough to be able to satisfy its demand for funds on globally competitive terms.
Governments of developing countries use these markets in seeking funds for government-
owned corporations in the process of privatizing.
The second reasons the opportunities for obtaining a reduced cost of funding (taking
into consideration issuing costs) compared to tat available in the domestic market. As
explained in Chapter 17, in the case of deb the cos will reflect two factors: (1) the risk free
rate, which is accepted as he interests rate in a U.S. Treasury security with the same maturity
or some other low-risk security (called the base rate); and (2) a spread to reflect the greater
risk that investors perceive as being associated with the issue or issuer.
A corporate borrower who seek reduced funding costs is seeking to reduce the spread.
The integration of capital markets throughout the world diminishes such opportunities.
Nevertheless, as discussed in the next chapter, imperfections in capital market throughout
the world prevent complete integration and thereby may permit a reduced cost of funds.
These imperfections, or market frictions, occur because of differences in security regulations
in various countries, tax structures, restrictions imposed on regulated institutional investors,
and the credit risk perception if the issuer. In the case common stock, a corporation seeks
to gain a higher value for its stock and reduce the market impact cost of floating a large
The third reason to seek funds in foreign markets is a desire by corporate treasures to
diversify their source of funding sources may encourage foreign investors who have different
perspectives of the future performance of the corporation. Two additional advantages of
raising foreign equity funds, form the perspective if US. Corporations include (1) some market
observers believe that certain foreign investors are more loyal to corporations an look at long-
term performance rather than short-term performance as o investors in the United States an
(2) diversifying the investors base reduce he dominance of U.S. institutional holdings and its
impact on corporate governance.
Finally, a corporation may issue a security denominated in a foreign currency as part
of its overall foreign currency management. For example, consider a U.S. corporation that
plans to build a factory in a foreign currency. Also assume that the corporation plans to sell
the output of the factor in the same foreign country. Therefore, the revenue will be
denominated in the foreign currency. the corporation then fees enhance rate risk: the
constructing costs are uncertain in U.S. dollars because during the construction period the
U.S. dollar may depreciate relative to the U.S. dollar. Suppose that the corporation arranges
debt financing for the plant in which it receives the proceeds in the foreign currency and the
liabilities are denominated in the foreign currency. This financing arrangement can reduce
exchange rate risk because the proceeds received will be in the foreign currency and will be
used to pay the construction costs and the projected revenue can be applied to service the
debt obligation.
Corporate Financing Week asked the corporate treasurers of several multinational
corporations why they used non domestics markets to raise funds. Their responses reflected
one or more of the reasons just cited. For example, the director of corporate finance of General
Motors said that the company uses the Eurobond market with the objective of Diversifying
funding sources, attract new investors can achieve comparable, if no, cheaper financing. A
managing director of Sears Roebuck stated that the company has a long-standing policy of
diversifying geographical [funding] sources and instrument to avoid reliance on any specific
market, even if the cost is higher. He further stated that Sears cultivates a presence in the
international market by issuing every three years or so.

Already issued financial assets trade in the secondary market. The key distinction between
a primary market and secondary market is that in the secondary market the issuer of the
asset dos not receive funds from the buyer. Rather, the existing issue changes and in the
secondary market, and funds flow from the buyer of the asset to the seller. In this section we
explain the various features of secondary markets. These features are common ton any toe f
financial instruments traded. We take a closer look at individual markets in later chapters.
Function of Secondary Markets
It is worthwhile to review once again the function of secondary markets. The secondary
market provides to an issuer of securities, whether the issuer is a corporation or a
governmental unit, regular information about the value of the security. The periodic trading
of the asset reveals to the issuer the consensus price that the assets commands in an open
market. Thus, firms can discover what value investors attach to their stocks, and firms and
no corporate issuers can observe the prices of their bonds and the implied interest rates
investors expected and demand from them. Such information helps issuers assess how well
they are using the funds acquired from earlier primary market activities and it also indicates
how receptive investors would be ton new offerings.
The other service a secondary market offers issuers is that it provides the opportunity
for the original buyers of the asset to reverse their investments by selling it for cash. Unless
investors feel confident that they ca shift fr one financial asset to another as they may deem
necessary they would harm potential issuers in one of two ways: either issuers would be
unable to sell new securities at all r they would have to pay a high rate of return, because
investors would demand greater compensation for the expected illiquidity of the securities.
Investors in financial assets receive several benefits from a secondary market. Such a
market obviously offers them liquidity for their assets as well as information about the assets
fair or consensus values. Further, secondary markets bring together many interested parties
and so can reduce the costs of searching for likely buyers and sellers of assets. Moreover, by
accommodating many trades, secondary markets keep the cost of transactions low. By
keeping the costs of both searching an transacting low, secondary markets encourage
investors to purchase financial assets.

Architectural Structural of Secondary Markets

There are different architectural structures that can be use in establishing a secondary
market for a financial asset. The two general architectural structures are order-driven and
quote-driven markets. Real-world financial markets use a blend of these structures for
different types of financial assets. To understand the difference between an order-driven and
quote-driven market, we must make clear who are the potential parties.

Potential Parties to a Trade

The potential parties to a trade include;
Natural buyers
Natural sellers
The natural buyer and natural sellers want to take a position for their own portfolio.
They can be retail investors or institutional investors.
A broker is a third party in a trade that half on behalf of a buyer or seller who wishes
to execute an order. In economic and legal terms. A broker is said to be an agent of the one
of the parties to the trade. What is critical to understand is that the brokerage activity does
not require the broker to buy and hold in inventory or sell from inventory the financial asset
that is the subject of the trade. Rather, the broker receives, transmits, and executes a
customers orders and in exchange for this service the brokers receives an explicit
A dealer is an entity that acts as an intermediary in a trade by buying and selling for
its own account. Basically, a dealer will buy a financial asset to place in its inventory or will
sell a financial asset from its own inventory. A dealer is said to take position in an asset.
Notice the distinction between a dealer buying and selling for its own account, who is acting
as an intermediary in a trade, and a natural buyer and natural seller purchase for their own
account. In acting in this capacity, a dealer is committing its own capital to accommodate a
trade sought by other parties. Hence, in contrast to a broker, a dealer is acting as a principal
in a trade. The potential income earned from this intermediary activity is the difference
between the price at which a dealer is willing to offer a financial asset to investors (the ask
price) and he price at which a dealer is willing to buy a financial asset from investors (the bid
price). The difference is referred to as the bid-ask spread.
A special type of dealer is called a market marker. This term describes a dealer who
has a special obligation in the secondary market. That special obligation is to use its capital
to make an orderly market for designated financial assets.

Order-Driven Market and Quote-Driven Market

Now lets see what we mean by an order-driven and quote-driven market. The difference is
based on how trading takes place and how the price is determined. In its purest sense, an
order-driven market is where all of the participants in the trade are natural buyers and
natural sellers and there is no dealer acting as an intermediary. The clearing price is
determined by the order flow of buy and sell orders. Another term used to describe an order-
driven market is auction market.
In a quote-driven market, rather than having the interaction of natural buyers and
natural sellers determine the price, the price is determined by the dealer based on prevailing
market information. The dealer then stands ready to buy and sell a financial asset at the
prices it quote. Because of the role played by the dealer in a quote-driven market, this market
structure is also referred to as a dealer market or dealership market.
Types of Order-Driven Markets
An order-driven market can be further classified as a continuous order-driven market or
periodic call auction.
In a Continuous order-driven market pieces are determined continuously throughout
the trading day as a buyer and sellers submit orders. For example, given the order flow at 10
A.M., the market clearing price of a financial asset may be $70; at 11 A.M. of the same trading
day, the market clearing price of the same financial asset, but with different order flows, may
be $70.75. Thus, in a continuous market, price may vary with the pattern if orders reaching
the market and not because of any change in the basic situation of supply and demand. We
return to this point later in this chapter.
The other type of order-driven market structure is the periodic call auction in which
orders are batched or grouped together for simultaneous execution at preannounced times.
For example, a periodic call auction can be at the opening of the trading day, the closing of
a trading day, or at designated times during the trading day. The auction may be oral or
written. In either case, the auction will determine or fix the market clearing price at a
particular time of the trading day. This use of the word fix is traditional and not pejorative
or suggestive of illegal activity. The price obtained for a periodic call auction can be
determined via a price scan auction or sealed bid auction.
In a price scan auction, an auctioneer announces tentative prices and the participants
physically present respond indicating how much they would be willing to buy and sell at each
tentative price. The market-clearing price is then determined by the price that will balance
the buy and sell orders. In a sealed bid/ask auction, bid price/ask price and quantities at
which a participant is willing to transact are submitted. Information about the order of a
party who participate in the auction is not disclosed to the other participants involved in the
auction. Buy and sell orders are then cumulated by.

In margin transaction, the broker is not free to lend as much as it wishes to the investor
to buy securities. The securities and exchange act of 1934 prohibits brokers from ending
more than a specified percentage of the market value of the securities. The initial margin
requirement is the proportion of the proportion of the total market value of the securities
that the investor must pay for in cash. The 1934 act gives the Board of Governors of the
Federal Reserve the responsibility to set initial margin requirements, under Regulations T
and U. The initial margin requirements vary for stocks and bonds and is currently 50%,
although it has been below 40%. The Fed also establishes a maintenance margin
requirement. It is the minimum amount of equity needed in the investors margin account
as compared to the total market value. If the investors is required to put up additional cash.
The investor receives a margin call from the broker specifying the additional cash to be put
into the investors margin account. If the investor fails to put up the additional cash, the
securities are sold.
As we will explain in Chapter 10, investors who take positions in the futures market
are also required to satisfy initial and maintenance margin requirements. Margin
requirements for the purchase of securities are different in concept form those in futures
markets. in a margin transaction involving securities, the initial margin requirements is
equivalent to a down payment; the balance is borrowed funds for which interest is paid (the
call rate plus a service charge). In the futures market, the initial margin requirments es
effectively good faith money, indicating that the investor will satisfy the obligation of the
futures contract. No money is borrowed by the investor.

Securities Finance we have seen that trading in securities involves more than just buying
securities and paying the full price for them and selling securities not owned and borrowing
securities to do so. Our simple illustrations use common stock to explain buying on margin
and short selling. However, other types of securities are financed or sold short by institutional
investor investors and trading desks at investment banks. For example, a hedge fund may
want to finance a $40 million position in a particular mortgage-backed security. Or the
trading desk of an investment banking firm may want to short $50 million of a particular
corporate bond and needs to borrow that particular corporate bond to cover the short sale.
These are common transactions by institutional investors and trading desks of investments
For the market to accommodate these types of transactions, mechanism must be
available in the marketplace where the financing of positions in securities can be done quickly
and at a reasonable cost and where securities can be borrowed so that short selling can take
place. The financing of positions in securities and the borrowing of securities fall into a little
known, but obviously important area of finance called securities finance that we mentioned
in the previous chapter. Securities finance involves two activities: securities lending and
repurchase agreements. We briefly describe each of these activities here.

Securities Lending in our description of short selling, we saw how an investor an benefit
from short selling. However, we led out an extremely important detail. The short seller sells
a security to a buyer. How does the short seller obtain the security to deliver to the broker
who then delivers the security to the buyer? Here is the short answer: the short seller borrows
the security from the broker. That short answer, however, masks the role of a major activity
in financial markets called securities lending and the motivation of the parties in a securities
lending transaction.
Securities Lending involves the temporary transferring of a security by one party to
another party. The party that transfer the security is called the security lender. The party
that needs the security is called the security borrower. The securities lending agreement
calls for the borrower to return the borrowed security to the security lender either on demand
or by a specified date.
During the period when the security lender has loaned the security to the security
borrow, the security lender faces the risk that the security borrower will not be able to return
the lent security t the security lender the concern is obviously that the market value od he
lent security will increase and the security lender then realizes a loss of the security borrower
fail to return the security that has appreciated in value. To protect itself, the security lender
will require that the security borrower post some type of collateral. The collateral can be
either cash or either securities most securities lending transactions involve the posting of
cash, and in our discussion we will describe what happen when there is cash collateral.
We know why the security borrower uses a security lending transaction bt what is the
economic motivation for the security lender? The security lender can earn a fee on the
security lent. To see how this happens, we must discuss he securities lending agreement in
a little more detail.
When there is cash collateral that is posted by the security borrower, the security
lender now has cash available to invest. The agreement ill call for the security lender to pay
to the security borrower a fee referred to as he rebates. The amount of the rebate is equal to
the amount of the cash collateral multiplied by the rebate rate. It may seem puzzling that
the security lender is paying a fee to the security borrower when the security lender is
allowing the security borrower to use its security. But the fat is that the security lender has
cash to invest. The security lender can incest that cash and earn a return. The expectation
of the security lender I that the return earned in the cash invested exceeds the rebate rate.
That is the security lenders economic motivation for lending the security.
Commercial banks and investment banks have groups to accommodate customers who own
securities and are willing to lend them. The securities lending groups assist customers in
negotiating the rebate rate, identifying acceptable counterparties in transactions, and
investing the cash collateral to generate a spread over the rebate rate.
Repurchase Agreements being able to finance positions in securities is critical in a financial
market. This can be done by using the securities purchased as collateral for a loan. The two
most common ways a market participant can borrow via a collateralized loan arrangement is
via margin buying as discussed earlier and a repurchase agreement. When the collateral is
common stock, buying on margin is the most common method used. Although buying on
margin is possible for bonds, typically financing is via a repurchase agreement.
A repurchased agreement, more popularly referred to as a repo, is the sale of security
with a commitment by the seller to buy the same security back from the purchaser at a
specified price at a designated future date. The price at which the seller must subsequently
repurchase the security is called the repurchase price, and the date that the security must
be repurchased is called the repurchase date. Basically, a repo is a collateralized loan, where
the collateral is the security sold and subsequently repurchased.
The term of the loan and the interest rate that the entity seeking financing agrees to
pay is called the repo rate. When the term of the loan is one day, it is called an overnight
repo; a loan for more than one day is called a term repo. The transaction is referred to as a
repurchase agreement because it calls for the sale of the security and its repurchase at a
future date. Both the sale price and the purchase price are specified in the agreement. The
difference between the purchase (repurchase) price and the sale price is dollar interest coast
of the loan.
For example, suppose a hedge fund has purchased $20 million of a particular security
and wants to hold it for 30 days. The hedge fund can use the repo market to obtain financing.
In the repo market the hedge fund can use the security as collateral for a loan. The hedge
fund would agree to deliver (sell) $20 million of the security to the customer and buy
(repurchase) the same security from the customer for $20 million in 30 days.
The advantage to the hedge fund of using he repo market for borrowing on a short-
term basis is that the rate is lower than the cost of bank financing. (the reason for this
explained later.0 for the lenders perspective, the repo market offers an attractive yield on a
short-term secured transaction that is highly liquid. We discuss the re as an investment
while in Chapter 20 where we discuss money market instruments.
Although the example illustrates how a hedge funds long position can be finance in
the repo market, market participant can cause the repo market t cover a short portion. For
example, suppose a hedge fund sold $50 million of a security ten days ago and must now
cover the position that is, deliver the security that s sorted and sell the security back at
some specified date, of course the hedge fund eventually would have to buy the security in
the market order to cover its short position, in this case, the hedge funds actually making a
collateralize on to the repo counterparty; that is m un this repo transaction the hedge fund
lending funds. The counterparty in the repo may be using the funds obtained form the
collateralized loan to create leverage.
There is a good deal of Wall Street jargon describing repo transactions. To understand
it, remember that one party is lending money and accepting a security as collateral for the
loan; the other party is borrowing money and providing collateral to borrow the money. When
someone lends securities in order to receive cash (i.e., borrow money), that party is said to
be reversing out securities. A party that lends money with the security as collateral is said
to be Reversing in securities. The expressions to repo securities and to do repo are also
used. The former means that someone is going to finance securities using the security as
collateral: the latter means that the party is going to invest in a repo, finally, the expressions
selling collateral and buying collateral are used to describe a party financing a security
with a rei on the one hand and lending on the basis of collateral on the other.
Despite the fact that there may be high-quality collateral underlying a reo transaction, both
parties to the transaction is exposed to credit risk. Why does credit risk occurs in a repo
transaction? Consider our initial example in which the hedge fund uses $20 million of an it
purchases as collateral to borrow. I the hedge fund cannot repurchase the security, the
counterparty keeps the collateral; if subsequent to the repo transaction t market value of the
security declines, the counterparty will own a security with a market value of the security
declines the counterparty will on a security with a market value less than the amount it lent
to the hedge fund, of the market value of the security rises instead, the hedge fund will be
concerned with the return of the collateral, hitch then has a market value higher than the
Because of this, repos are carefully structured to reduce credit risk exposure.
The mount lent should be less than the market value of the security used as collateral,
thereby providing the lender with some cushion should the market value of the security
decline. The amount by which the market value of the security used as collateral exceeds the
value of the loan is called the repo margin. repo margin is also referred o as the haircut.
Repo margin is generally between 1% and 3%. For borrowers of lower creditworthiness
and/or when less liquid securities are used as collateral, the repo margin can be 10% or
more Another practice to limit credit risk is to mark the collateral to market on a regular
basis. (marking a position to market means according the value of a position at its market
value.) when market value changes by a certain percentage, the repo position is adjusted
There is not one repo rate in the market. The rate varies from transaction t transaction
depending on a variety of actors: quality of collateral, term of the repo, delivery requirement,
availability of collateral and the prevailing federal funds rate. The higher the credit quality ad
liquidity of the collateral, the lower the repo rate. The effect of the term of the repo on the
rate depends in the shape of the yield curve. The more difficult it is to obtain the collateral,
the lower the repo rate. The effect of the term of the repo on the rate depends on the shape
of the yield curve. The more difficult it is to obtain the collateral, the lower the repo rate. To
understand why this is so, remember that the borrower (or equivalent the seller of the
collateral) has a security tat lenders of cash want, for whatever reason. Such collateral is
referred to as hot or special collateral. (collateral that does not have this characteristic is
referred to as general collateral). The party that needs the hot collateral will be willing to
lend funds at a lower repo rate in order to obtain the collateral.
Whereas the above factors determine the repo rate on a particular transaction, the
federal funds rate determines the general level of repo rates. The repo rate generally will be a
rate lower than the federal funds rate because a repo involves collateralized borrowing,
whereas a federal fuds transaction is unsecured borrowing.
Role of Brokers and Dealers in Real Markets
Common occurrences in real markets keep them from being theoretically perfect. Because of
these occurrences, brokers and dealers are necessary to the smooth functioning of a
secondary market.
One way in which a real market might not meet all the exacting standards of a theoretically
perfect market is that many investors may not be present at all times in the marketplace.
Further, a typical investor may not be skilled in the art of the deal is completely informed
about every facet of trading in the assets. Clearly, most investors need someone to receive
and keep track of their orders for buying or selling, to find other parties wishing to sell or
buy, to negotiate for good prices, to serve as a focal point for trading, and to execute the
orders. The broker performs all of these functions. Obviously, these functions are more
important for the complicated trades such as the small or large trade, than for simple
transaction or those of typical size.

Dealers as Market Markers

A real market might also differ from the perfect market because of the possibly frequent event
of a temporary imbalance in the number of buy and sell orders that investors may place for
any security at any one time. Such unmatched or unbalanced flow causes two problems.
First, the securitys price may change abruptly even if there has been no shift in either supply
or demand for the security. Second, buyers may have to pay higher than market-clearing
prices (or sellers accept lower ones) if they want to make their trade immediately.
For example, suppose the consensus price for ABC security is $50, which was
determined in several recent trades. Also suppose that a flow of buy orders from investors
who suddenly have cash arrives in the market, nut is not matched by an accompanying
supply of sell order. This temporary imbalance could be sufficient to push the price of BC
security t, say, $55. Thus, the price would change sharply even though no change in any
fundamental financial aspect of the issuer occurred. Buyers wh0 want to buy immediately
must pay $55 rather than $50, and this difference can be viewed as the price of immediacy.
By immediacy, we mean that buyers and sellers do not want to wait for the arrival of sufficient
orders on the other side of the trade, which would bring the price loser to the level of recent
The potential for imbalances explains the need for the dealer, who stands ready and
willing to buy a financial asset for its own account (add to an inventory of the security) or sell
from its own account (reduce the inventory of the security). At a given time, dealers are willing
to buy a security at a price (the bid price) that s less than what they are willing to sell the
same security for (the ask price).
In the 1960s economists George Stigler and Harold Demsetz analyzed the role of
dealers in securities markets. They viewed dealers as the suppliers f immediacy the ability
to trade promptly to the market. The bid-as spread can be viewed in turn as the price
charged by dealers for supplying immediacy, together with short-run price stability
(continuity or smoothness) in the presence of short-term order imbalance. Dealers play two
other roles: they provide better price information to market participants, and in certain
market structures they provide the services of an auctioneer n bringing order and fairness to
a market.
The price stabilization role relates to our earlier example of what may happen to the
price of a particular transaction in the absence of any intervention in the case of a temporary
imbalance of orders. By taking the opposite side of a trade when no other orders are available,
the dealer prevents the price from materially diverging from the price at which a recent trade
was consummated.
Investors are concerned with immediacy, and hey also want to trade at reasonable
prices, given prevailing conditions in the market. Although dealers cannot know with
certainty the true price of a security, they do occupy a privileged position in some market
strictures with reset to the flow of market orders. They also enjoy a privileged position
regarding limits orders, the special orders that can be executed only if the market price of
the security changes in a specified way. (see Chapter 13 for more information on limits
Finally, the dealer acts as an auctioneer in some market structures, thereby providing order
and fairness in the operations of the market. For example, as we will explain in Chapter 13,
the market maker n organized stock exchange in the united states performs this function by
organizing trading o make sure that the exchange rules for he priority of trading are flow.
The role of a market maker in a ca market structure is that of an auctioneer. The market
maker dies not take a position in the traded security as dealer does in continuous market.
What factors determine the price dealers should charge for the services they provide?
Or equivalently, what factors determine the bid-ask spread? On f the most important is the
order processing costs incurred by dealers such as the cost of equipment necessary to do
business and the administrative and operations staff. The lower these costs, the narrower is
the bid-as spread. With the reduced cost of computing and better-trained personnel, these
costs have declined since the 1960s.
Dealers also have to be compensated for bearing risk. A dealers position may involve
carrying inventory of a security (a long position) or selling a security that is not in inventory
(a short position). Three types of risks are associated with maintaining a long or short position
in a given security. First, the uncertainty about the future price of the security presents a
substantial risk. A dealer who takes a long position in the security is concerned that the price
will decline in the future; a dealer who is a short position in concerned that the price will
The second type of risk concerns the expected time it will take the dealer t invited a
position and its uncertainty, which, in turn, depends primarily on the rate at which buy and
sell orders for the security reach the market (i.e., the thickness of the market). Finally,
although a dealer may be able to access better information about order flows than the general
public, in some trades the dealer takes the risk of trading with someone in possession of
better information. This situation results in the better informed trader obtaining a better
price at the expense pf the dealer. Consequently, in establishing the bid-ask spread for a
trade, a dealer will assess whether the trader may hold better information.
Market Efficiency
The term efficient, used in several contexts, describes the operating characteristics of a
capital market. A distinction, however can be made between an operationally (or internally)
efficient market and a pricing (or externally) efficient capital market.
Operational Efficiency
In an operationally efficient market, investors can obtain transaction services as cheaply
as possible, given the cost associated with furnishing those services. For example, in national
equity markets throughout the world the degree of operational efficiency varies. At one time,
brokerage commissions in the United States were fixed and the brokerage industry charged
high fees. That changes in May 1975, as the U.S. exchanges were forced to adopt a system
of competitive and negotiated commissions. Non U.S. markets continue to move toward
more competitive brokerage fees. France, for example, adopted a system of negotiated
commissions for large trades in 1985. In its big bang of 1986, the London Stock Exchange
abolished fixed commissions.
Commissions are only part of the cost of transacting as already noted. The other part
it is the dealer spread. Bid-ask spreads for bonds vary type of bond. Even with the U.S.
treasury securities are much smaller than for other bond. Even with the U.S. treasury
securities market, certain issues have a narrower bid-ask spread than other issues other
components of transaction cost are discussed later in this chapter.
Pricing Efficiency
Pricing efficiency refers to a market where prices at all times fully reflect all available
information that is relevant to the valuation of securities. That is relevant information about
the security is quickly integrated into the price of securities.
In his seminal review article on pricing efficiency, Eugene fama points out that in order
to test whether a market is price efficient, to definitions are necessary. First, it is necessary
to define what is means that prices Fully reflect information. Second the relevant set of
information that is assumed to be fully reflected in prices must be defined.
Fama, as well as others defines, Fully reflects in term of the expected return form
holding security the expected return over some holding period is equal to expected cash
distribution plus the expected price change, all divided by the initial price. The price
formation process defined by fama and others is that the expected return one period from
now is stochastic (i.e., random) variable that already takes into account the relevant
information set.
In defining the relevant information set that prices should reflect, Fama classified the
ricing efficiency of a market into three forms: weak, semi-strong, and strong. The distinction
between these forms lies in the relevant information that is hypostasized within the price of
the security. Weak efficiency means that the price of the security reflects the past price and
trading history of the security. Semi-strong efficiency means that the price of the security
reflects all public information, which includes but is not limited to historical price and trading
patterns. Strong efficiency exists in a market where the price of a security reflects all
information, whether or not it is publicly available.
A price-efficient market carries certain implication for the investment strategy investors
may wish to pursue. Throughout this book, we refer to various active strategies employed by
investors. In an active strategy, investor seek to capitalize on what they perceive to be the
mispricing of a security or securities. In a market that is price efficient, active strategies will
not consistency generate a return after taking into consideration transaction costs and the
risks associated with a strategy that is greater than simply buying an holding securities. In
certain markets that empirical evidence suggest are price efficient, investors may pursue a
strategy of indexing, which simply seeks to match the performance of some financial index.
We will look at the pricing efficiency of the stock market in Chapter 13; the greater amount
of empirical evidence exists in this market.

Transaction Costs
In an investment era where one-half of one percentage point can make a difference when
money manager is compared against in a performance benchmark, an importance aspect of
the investment process is the cost of implementing an investment strategy. Transaction costs
are more than merely brokerage commissions they consist of commissions, fees, execution
costs, and opportunity costs.
Commissions are the fees paid o brokers to trade securities. In May 1975 commissions
became fully negotiable and have declined dramatically since then. Included in the category
of fees are custodial fees and transfer fees. Custodial fees are the fees charged by an
institution that holds securities in safekeeping for an investor.
Execution Costs represent the difference between the execution price of a security
and price that would have existed in the absence of the trade. Execution costs can be further
decomposed into market (or price) impact and market timing costs. Market impact cost is
the rest of the bi-ask spread and a price concession extracted by dealers to mitigate their risk
an investors demand for liquidity is information-motivated. Market timing cost arises when
an adverse price movement of the security during the time of the transaction can be
attributed in part to other activity in the security and is not the result of particular
transaction. Execution costs then are related to both the demand liquidity and the trading
activity on the trade date.
A distinction can be made between information-motivated trades and information
less trades. Information-motivated trading occurs when investors believe theory possess
pertinent information not currently reflected in the securitys price. This style of trading tends
to increase market impact because it emphasizes the spread of execution, or because the
market marker believes a desired trade, is driven by information and increases the bid-ask
spread to provide some protection. It can involve the sale of one security in favor of another.
Information less trades result form either a reallocation of wealth or implementation of an
investing strategy that utilizes only existing information. An example of the former is a
pension funds decision to invest cash in the stock market. Other examples of information
less trades include portfolio rebalances, investment of new money, or liquidations. In these
circumstance the demand for liquidity alone should not lead the market marker to demand
the significant price concessions associated with new information.
The problem with measuring execution cost is that the true measure which is the
difference between the price of the security in the absence of the investors trade and the
execution price is not observable. Furthermore, the execution prices depend on supply and
demand conditions at the margin. Thus, the execution price may be influenced by competitive
trades who demand immediate execution, or other investors with similar motive for trading.
Then, the execution price realized by an investor is the consequence of the structure of the
market mechanism, the demand for liquidity by the marginal investor, and the competitive
forces of investors with similar motivations for trading.
The cost of not transacting represents an opportunity cost. Opportunity cost may arise
when desired trade fails to be executed. This component of costs represents the difference in
performance between investors desired investment and the same investors actual
investment after adjusting for execution costs, commissions, and fees/
Opportunity costs are characterized as the hidden cost of trading; some analysis
suggest that the shortfall in performance of many actively managed portfolio is the
consequence of failing to execute all desired trades. Measurement of opportunity cost is
subject to the same problems as measurement if execution costs the true measure of
opportunity cost depend on knowing the resulting performance of security of all desired
trades were executed at the desired time across an investment horizon. Because these desired
trade were not executed, the benchmark is inherently unobservable.

The primary market involves the distribution to investors if newly issued securities.
The SE is responsible for regulating the issuance of newly issued securities, that the major
provisions set forth in the Securities Act of 1933. The act requires that the issuer file
registration statement with the SEC and that the registration statement e approved by the