1.4 Financial Markets

A financial market is a broad network through which participants can borrow, lend, and invest. The market can be for both physical and non-physical assets. The primary purpose of a financial market is to be a channel through which suppliers, who have excess money, and demanders, who need money, are brought together. Individual households are generally net suppliers, as they spend less money than they earn. Governments and companies are typically net demanders, as they spend more money than they generate in cash flow.

For most financial assets, the demand curve is downward sloping, suggesting that as the price for the asset increases, the quantity of that asset demanded decreases, and vice-versa. This is rational consumer behavior. If the cost of apples doubled overnight, you would probably respond by buying fewer apples. In contrast, the supply curve is upward sloping, indicating that as the price for an asset increases, the quantity of that asset supplied also increases, and vice-versa. Wouldn’t you rather sell something at a higher price? In equilibrium, suppliers and demanders agree on both price and quantity.

Primary versus Secondary Markets

Many financial market participants, such as government agencies and corporations, access money in financial markets by issuing financial securities. As discussed previously, these securities are often categorized as either debt or equity. The primary market is where new securities are bought and sold. This is the market in which financial market participants raise new money. An example of a primary market transaction is if you buy stock directly from an issuing company. The company receives cash from you, the investor, in exchange for ownership rights. The secondary market is where existing, or old securities are traded. This market allows financial market participants the opportunity to transfer securities and money between each other. An example of a secondary market transaction is if you already own stock in a company and then sell that stock to another financial market participant.

Debt Markets

The debt markets allow companies to raise money externally without sacrificing ownership rights. While this is not a hard-and-fast rule, the short-term debt market (or money market) consists of loans that are due within one year, whereas the long-term debt market (or bond market) consists of loans that are due in more than a year. As discussed earlier, debt securities are issued by governments, corporations, and institutions needing short- and long-term financing. For example, suppose your local community is in desperate need of a new school. The local government, also referred to as a municipality, can issue a bond to raise money to pay for the school. Investors provide the government with cash in exchange for an agreement that the money will be returned in the future plus interest. The government can then use its taxing power to generate income to pay off the investors. The beauty of municipal bond investments is that they are often exempt from federal, state, and local taxation.

Private Stock Markets

Private stock markets allow small- and middle-sized businesses to raise money from investors in exchange for ownership rights. Banks are generally not interested in making loans to start-up companies, or even to middle market companies with little track record. These companies often rely on private equity financing. There are a number of common avenues for this type of financing.

Venture capital (VC) firms pool money together from investors, such as high-wealth individuals and institutions. VC firms then provide financing to new, often high-risk start-ups. To limit the amount of risk exposure, funding is provided in stages. In exchange for their capital, venture capital firms often demand a voice in business decisions.

Private equity (PE) firms pool money together from investors, such as high-wealth individuals and large institutions. PE firms then use these funds to buy shares of private companies or obtain a controlling interest in public companies with the intent of taking them private. Private equity firms often purchase 100% ownership of businesses and, therefore, obtain complete control over the businesses’ operations.

The rapid growth of technology and influence of social media have introduced new types of equity financing options. Equity crowdfunding is a type of financing that is obtained from a large number of investors, typically via social media or designated crowdfunding websites. These investors do not need to be wealthy, as they generally provide relatively small amounts of capital.

The over-the-counter (OTC) stock markets are operated by registered broker-dealers that buy and sell stock of domestic and foreign companies that are privately held. While some of the companies in these markets are large and legitimate, others are shells and spammers. To help with transparency, in 2007, the OTC Markets Group decided to separate firms into three separate venues based primarily on information disclosure. The OTCQX is referred to as the “best market,” which requires companies to disclose financial information to the public. The companies in this venue tend to be larger and more established. The OTCQB is classified as the “venture market,” which does not have the same disclosure standards as the OTCQX, as many of the firms in this tier are in their early stages. The OTC Pink market is the “open” market which allows any security to be traded. This market is also often referred to as the “penny stock” market, as many low-priced securities trade here. The fascinating thing about the OTC Pink market is that you need a very small price change to earn a large percent return on an investment. For instance, if a security that is trading for $0.01 increases by one penny to $0.02, you have doubled your money.

Public Stock Markets

Many private companies reach a certain stage where the only way to continue to grow and expand is to widen their investor base through an initial public offering (IPO), when the company offers ownership stock to the public for the first time. The IPO process generally begins with hiring an investment banking firm to underwrite the issuance of ownership shares. The underwriter will use its distribution network to sell stock for its client company and raise money. Oftentimes more than one investment banking firm will represent a private company, in which case each of the underwriters is referred to as a syndicate. For instance, when Facebook Inc. (now Meta Platforms, Inc.) began its IPO process, it hired several lead underwriters: Morgan Stanley, J.P. Morgan, Goldman Sachs, Merrill Lynch, Barclays Capital, and Allen & Company. The private company, along with its underwriter(s), will then go on a roadshow where they meet with high-wealth investors and institutions to gauge interest and establish an issuing price. In exchange for their services, the underwriters often charge a substantial fee, which is a percent of the total IPO proceeds, ranging from 1% to 7%. In the case of Facebook, the syndicate charged a 1.1% fee that was estimated to be worth about $176 million, as the total capital raised for the company amounted to approximately $16 billion.1

To begin the transfer of ownership to the public, the private company lists its shares on an organized stock exchange, such as the New York Stock Exchange (NYSE) or NASDAQ. The NYSE is one of the oldest, and most important, stock exchanges in the world. The NYSE was established in 1792 and has a physical trading floor located on Wall Street in New York City. The NASDAQ was founded much more recently in 1971 and does not have a physical trading floor. Therefore, one key difference between the two exchanges is that the NYSE involves both people and technology, whereas the NASDAQ is entirely computer-based. However, even the NYSE has moved to a more computer-based approach, as the vast majority of transactions are accommodated digitally. Both exchanges employ, and outsource, market makers who are charged with maintaining orderly trading in their listed securities and providing liquidity. However, the NYSE operates with designated market makers (DMMs), formerly known as specialists, who are separately charged with providing stability to assigned stocks. The NASDAQ operates with dealers who compete with one another as they buy and sell stock from their own accounts.

In order to remain listed on a public exchange, companies must maintain certain listing requirements, such as an aggregate pre-tax income for the last three years of $10 million or a minimum stock price of, say, $4. The listing requirements are made available to the public by the stock exchanges. The public stock markets officially open at 9:30 a.m. EST and close at 4:00 p.m. EST. There is the opportunity for after-hours trading, but markets are much less liquid, so buyers beware.

Financial Market Efficiency and Liquidity

A well-functioning or efficient market is one in which asset prices accurately reflect all relevant information. However, information asymmetries between buyers and sellers can cause prices to deviate from equilibrium. Suppose the engine light in your new Jeep Wrangler starts flashing, so you take it into a nearby auto mechanic. The mechanic gives you a cost breakdown for the repairs that ends up being $2,000, including $1,500 for a new axle and $500 for labor. How do you know you are getting a good price? Unless you have worked with cars before, you probably do not know what it costs for the part or how labor-intensive the repair is. The mechanic has more information than you, which can lead to price gouging. A way for you to overcome this problem is by obtaining multiple bids from different mechanics. Because information is readily available to most people via the internet, prices for many goods and services have become more efficient. Therefore, investors are able to make better-informed decisions in efficient markets, as they are confident in the prices.

The liquidity of a particular market is nearly as important as fair and efficient prices. Liquidity is defined as the ability to convert an asset into cash quickly, at a low cost, and without substantially lowering its value. You do not want to get stuck holding an asset that you are unable to sell—especially if you are in desperate need of cash. The liquidity of an asset depends greatly on how active the market is. Financial assets with less-active markets will be more costly to buy and sell. One measure that is used frequently in assessing an asset’s liquidity is the bid-ask spread. This is the difference between the best available bid and ask prices. These prices are often set by financial intermediaries, and the spread represents the cost to trade.