1.3 Primary Financial Markets

Along with an understanding of the various types of securities, it might be important to know some details about how firms issue these securities. In this section, we will discuss primary financial markets, that is, the markets in which these securities are first issued. Like other types of markets where buyers and sellers meet, primary financial markets are where the issuers (the firms) and the buyers (the investors) will engage in an exchange. We will begin by discussing the issuance of bonds, and we will then discuss the issuance of stocks.

To understand how the primary market works, we need to understand what a syndicate is. A syndicate is a group that is temporarily formed to handle a bond or stock issue. Syndicates are generally made up of large investment banks or other types of institutional investors. These large investment banks that make up a syndicate might also be the underwriters of the security issue. An underwriter has the responsibility of determining the value of the security and then, in some cases, the underwriter will purchase all of the securities from the issuer and then sell them to other investors.

In general, a firm issuing a bond can place the bonds with a syndicate in two ways. The first way is through a competitive sale. Those wishing to underwrite the bond issue will submit bids (on the bond’s prices and interest rate) to the issuing firm. The firm will then select the underwriter that offered the highest price and lowest interest rate. The underwriter will then sell the bonds to various investors at (hopefully) a slightly higher price than that at which the bonds were purchased. The second way is through a negotiated sale. Like the competitive sale, a negotiated sale is the process of underwriters submitting proposals, including bids. However, this latter type of sale involves a more thorough interview process with the underwriters. Further, the issuing firm will carefully select the management team that will place these bonds.

The primary market for stock issuance works in a similar way to the bond primary market. However, some terminology is different. A firm that is going public (or selling shares of ownership for the first time) is going to perform an initial public offering (IPO). These IPOs are sometimes called new equity offerings. However, much of the underwriting occurs in a similar manner, which we have discussed above.