BUS202: Principles of Finance

There are three main types of market organization that facilitate trading of securities: auction market, brokered market, and dealer market.

TERMS

• swaps

  A swap is a derivative in which counter parties exchange cash flows of one party's financial instrument for those of the other party's financial instrument.

• auction market

  an exchange where goods and services are offered up for bid, bids are taken, and then sold to the highest bidder

• forwards

  A non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today.

• dealer market

  an exchange where institutions are assigned to a particular security and trade out of their own account

• securities

  Synonymous with "financial instrument". A tradable asset of any kind; either cash, evidence of an ownership interest in an entity, or a contractual right to receive or deliver cash or another financial instrument.

Security Markets

The securities market is an economic institute where sale and purchase transactions of securities between subjects of economy take place according to demand and supply. These can be broken down into different types based on what is being traded. They are also differentiated by structure. The primary market is the part of the capital markets that deals with the issue of new securities. The secondary market, also known as the aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold. After the initial issuance, investors can purchase from other investors in the secondary market.

The major stock exchanges are the most visible example of liquid secondary markets - in this case, for stocks of publicly traded companies. Exchanges such as the New York Stock Exchange, Nasdaq, and the American Stock Exchange provide a centralized, liquid secondary market for the investors who own stocks that trade on those exchanges. Most bonds and structured products trade "over the counter," or by phoning the bond desk of one's broker-dealer. Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities, or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.

In the U.S., over-the-counter trading in stock is carried out by market makers that make markets in OTCBB and Pink Sheets securities using inter-dealer quotation services such as Pink Quote (operated by Pink OTC Markets) and the OTC Bulletin Board (OTCBB). OTC stocks are not usually listed nor traded on any stock exchanges, although exchange listed stocks can be traded OTC on the third market. An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. Forwards and swaps are prime examples of such contracts.

Types of Market Organization

There are three main types of market organization that facilitate the trading of securities: an auction market, a brokered market, and a dealer market. Hybrids of these types may also exist.

In the auction market format, buyers and sellers are brought together directly, announcing the prices at which they are willing to buy or sell securities. "Orders" are centralized by the market, so highest bidders and lowest sellers are exposed to each other. The New York Stock Exchange is a notable secondary market that is structured as an auction market. The NYSE trades in a continuous auction format, where traders can execute stock transactions on behalf of investors. They will gather around the appropriate post where a "specialist" acts as an auctioneer in an open outcry auction market environment to bring buyers and sellers together and to manage the actual auction.

Broker markets are usually only used for securities that have no public market, necessitating the middleman in the form of a broker. When a client asks their broker to fill an order, it is the broker's job to track down trading partners. The broker provides information about potential buyers and sellers and earns a commission in return. Municipal bonds are often traded in this way.

Dealer markets, also called quote-driven markets, centers on market-makers (or dealers) who provide the service of continuously bidding for securities that investors want to sell and offering securities that investors want to buy. This person or company quotes both a buy and a sell price in a financial instrument or commodity held in inventory. Dealers earn a profit on the bid-offer spread. Most foreign exchange trading firms are market makers and so are many banks. The market maker sells to and buys from its clients and is compensated by means of price differentials for the service of providing liquidity, reducing transaction costs and facilitating trade. The NASDAQ, many OTC markets, and the Forex are structured this way.