1.5 The Role of Financial Markets

Financial markets, while fairly sophisticated in the way they operate, play an important role in society. From the firm’s perspective, these markets have reduced the cost of borrowing from the public or selling ownership to the public. Think of pharmaceutical companies that are in need of financing to produce the latest drug that can treat cancer. Without a market that allows buyers and sellers to exchange, it would become extremely costly for companies to increase their production. Financial markets reduce the cost to companies of obtaining financing by providing liquidity to those that wish to trade securities.

In the previous section, we discussed two large secondary financial markets: the NYSE and NASDAQ. The NYSE has a single individual with the title of specialist who provides liquidity. That is, the specialist is hired by the NYSE to provide a “fair and orderly” market, meaning the specialist is to hold an inventory of a particular stock and must be willing to buy from those that wish to sell and sell to those that wish to buy. Because the specialist faces risk in holding an inventory of a stock that is fluctuating in price, the specialist will charge a slightly higher ask (or offer) price to those that want to buy and will be willing to pay a slightly lower bid price to those that want to sell. For example, the price of some stock is approximately $100 per share. Suppose an investor submits an order to buy the stock. The specialist might only be willing to sell for $100.03. A few minutes later, an order is submitted by another investor to sell the stock to the specialist. However, the specialist might only be willing to buy from the seller for $99.97. The difference between the bid price and the ask price is called the bid-ask spread. In this example, the bid-ask spread is $0.06. This is the compensation to the specialist for the risk that he or she bears for his or her willingness to provide liquidity. A similar process is followed for NASDAQ stocks with the exception that there are multiple dealers providing liquidity.