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The stock market is vast and complicated. For new investors, it might be intimidating to even make sense of how things work in the markets. That said, the markets can be broken down into smaller submarkets for the sake of better understanding. By doing so, it is important for investors to understand how each market works and how they interact with one another. By broad categorization, the stock market can be deconstructed into primary market and secondary market.
The primary market refers to the market where securities are created. In this market, stocks and bonds are created and traded for the first time by an underwriting company/issuers, which are often by an investment bank. Investors do not buy and sell the stocks and bonds from one another but buy the securities directly from the banks that are responsible for issuing them.
1.2. Types of primary market offerings
The most common transaction in the primary market is initial public offering (IPO) or public issue. The IPO process takes place when a private company wants to become public to take advantage of the capital raised by public investors. For example, if company A wants to raise capital to finance its business strategies in the future, it can go through an IPO process by hiring a bank as an underwriter. The bank does research into the company and fix on the issuing price of $15 per share. Investors who are interested in owning equity shares from company A can do so by buying shares directly from the issuing bank.
To understand more how exactly the IPO process works, please refer to this article
Another activity in the primary market is rights issue. A rights (offering) issue allows companies to raise additional equity capital through the primary market even when their securities have entered the secondary market. To illustrate, in the primary market, companies can approach existing investors and offer them the opportunity to buy more shares for a limited time, often at a discounted price. In a sense, rights offering works in a similar way to stock options. Both of them allow investors to purchase more shares at the primary market (directly from the issuing agency), but you don’t have to exercise your right. That’s why it is called a rights issue.
Other types of transactions in the primary market include private placement and preferential allotment. Private placement allows companies to sell directly to more significant investors such as hedge funds and banks without having to make shares publicly available. In other words, a private placement is a sale of stock shares or bonds to a preselected list of investors and institutions (often are wealthy individual investors, banks, financial institutions, mutual funds, insurance companies, and pension funds). On the other hand, preferential allotment issues shares to a select group of investors at a special price not available to the public. These two types of primary market offering may sound similar, but there are some subtle differences between them.
Preferential Allotment | Private Placement | |
Definition | The issuing of shares or securities to a list of chosen investors on a preferential basis | The offering of securities by a company to a selected group of investors |
Investors | Any investors who want to obtain a stake in the company | Investors chosen by the discretion of the offering company |
Time period | Should be allocated within a time span of 2 months from the date of receipt of funds | Should be allocated within 12 months followed by passing of a special resolution |
2.1. Definition
Definition: The secondary market, commonly referred to as the stock market or bond market, includes all the stock exchanges throughout the world. In the secondary market, investors trade previously issued securities without the issuing company’s involvement. Unlike in the primary market where investors can receive the stake in a company from that offering company or through the underwriting bank hired by that company, in the secondary market, investors deal with other investors who own shares in the company.
2.2. Types of secondary market offerings
The secondary market can be broken down into two types: auction market and dealer market.
In the auction market, all individuals and institutions gather in one area and announce the prices at which they are willing to buy or sell. In the auction market, buyers enter competitive bids and sellers submit competitive offers at the same time. The New York Stock Exchange (NYSE) is an example of an auction market. The prices that appear in the market are the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept.
In the dealer market, participants join the market using an electronic network. The dealers hold an inventory of securities, and they buy or sell their securities with market participants. These dealers profit from the difference between the prices at which they buy and sell the securities. The theory is that competition between dealers will provide the most competitive prices for investors. A dealer market might often be called an over-the-counter market. Over-the-counter market (OTC) refers to an unorganized market where trading occurs for stocks that are not listed publicly on stock exchanges such as NYSE or Nasdaq. Securities traded this way are mostly penny stocks or are from very small companies.
Primary Market | Secondary Market | |
Definition | Market where new shares are created | Market where already issued shares change hands from investors to investors |
Types of purchasing | Direct | Indirect |
Financing Capability | Provide capital to issuing company to fund budding enterprises | Provide no funding to companies |
Times of transactions | Only once | Multiple times |
Buying and Selling | Between company and investors | Among different investors |
Who profits? | Company | Investors |
Intermediary | Underwriters | Brokers |
Price | Fixed price | Fluctuates depending on market force |
4. Other types of market
There are several over less common types of market you will often hear thrown around. Other than the primary and secondary markets, you will often encounter the terms “third” or “fourth” markets. Both of these markets do not concern individual investors. The third market is made up of OTC transactions between broker-dealers and large institutional investors. The fourth market is made up of transactions between institutions. Both of these markets involve large volumes of shares, so they are not traded in stock exchanges, which otherwise would have greatly affected the security prices. With access to third and fourth markets being limited, their activities have little to know effect on the average investor.
Conclusion: Primary and secondary markets’ individual operation and the interaction with each other play an important role in the strengths of the financial markets and the mobility of money across different entities. Primary market encourages the flow of money between the investors and company, while the secondary market expands the flow to more individual investors. People often say in finance that what you don’t know might come back and hurt you. Understanding the two markets is therefore important to the understanding of how the economy and finance work, and it can save you from some really big losses.
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