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How the Market Works

Pertaining to the title of this article, we’re talking about the capital markets and the way they work. Before going any further, a clear understanding of the capital markets is essential.

Capital markets are financial markets where investments and other financial assets are bought and sold. These include long-term debt instruments and equity-backed securities. Capital markets include primary markets and secondary markets.

An Overview of Primary and Secondary Capital Markets

New stocks and bonds sold by a company for the first time always happen in the primary markets. The new issues are initial public offerings and, potential investors purchase these securities subject to review by an underwriting firm.

The IPOs issued in primary markets are priced low and are highly volatile in nature since demand cannot be predicted. A primary market is a place where companies go all out to sell all the securities in a short period to meet their targets.

A company that wishes to raise equity in the primary market should first enter the secondary market. They can achieve this through a rights issue or rights offering. Companies can sell directly through a hedge fund and, shares are not available for public offering.

Secondary markets are where company securities are traded after selling the initial offering on the primary markets. The most common secondary markets are the Stock Markets. Small investors and almost anyone can purchase securities on the secondary market.

Prices of securities on the secondary markets fluctuate depending on supply and demand. It’s different from the primary markets where IPOs are set beforehand. Post the initial offering the issuing company is not involved in any way for trading between investors.

Secondary Market Categories

The secondary market comprises of:

The Auction Market includes competitive bids by the buyers and competitive offers by the sellers. In other words, it’s a place of trade where buyers and sellers negotiate between the highest price willing to pay and the lowest price willing to accept, respectively.

The Dealer Market is a financial market where several dealers trade electronically through dealers called market makers. Dealers trade on their own behalf and provide transparency of prices they are willing to accept to buy or sell securities.

The auction market is different from the deal market in the sense that there is a single and centralized point of contact facilitating trading by tying up buyers and sellers.

Broker Market

This is yet another category of financial markets that calls for a specific level of expertise to facilitate a transaction. A defined buyer and seller are the prerequisite for a trade to happen in a dealer market.

The primary differences between dealer markets and broker markets are:

  • Brokers trade on behalf of others and, dealers trade for themselves
  • Brokers are the intermediaries between two parties and, dealers are the primary buyers and sellers
  • Brokers cannot buy or sell securities but, dealers have the right to do so
  • Since brokers are the intermediaries between buyers and sellers, they earn a commission. Dealers are the primary traders and hence, receive no commission

Capital Markets and Stock Markets

We often use the terms capital market and stock market interchangeably. However, there is a principal difference between the two commonly misunderstood terms.

Capital market is a comprehensive spectrum comprising of tradable assets and financial securities like bonds, contracts, derivatives, futures and other debt instruments. Coming to stock markets, they are the specific category of capital markets that trade only in shares of corporations.

More than a difference, the stock market is a major division of the capital markets.

Stocks and their Significance

Stocks are a type of financial security signifying proportionate ownership in the issuing company. Companies primarily issue stocks to the public to raise capital for day-to-day business operations. The buyer of the stock is the shareholder and, he/she is entitled to claim the company’s earnings in proportion to the number of stocks owned.

Stockholders have ownership in the issuing company. However, they own only the shares issued by the company and, not the company itself. Corporations are considered to be legal persons that own their own assets. This stresses on the fact that corporate property is distinct from shareholders property.

This significantly reduces the liability of the shareholders and the corporations. Even if the company goes bankrupt, your personal assets and your shares are not affected. Of course, the value of shares does reduce drastically. In case a shareholder goes bankrupt, he/she cannot sell company assets to compensate for the same.

How do Stock Markets Work?

Stock markets operate similarly to an auction house and, through a network of stock exchanges. Several corporations list their shares and stocks on a stock exchange platform to raise funds for their operations and expansion.

The most popular stock exchanges in the world are the New York Stock Exchange and Nasdaq.

Buyers and sellers come together to trade in shares and, the stock exchange keeps track of supply and demand for all the listed stocks. The supply and demand are the driving force behind the price for securities. It also helps determine the level of market participation by the buyers and sellers.

The bid-ask spread takes place comprising of the amount buyers are willing to pay and, sellers are willing to accept.

Remember, stock exchanges are secondary markets and, companies do not trade their own stocks regularly except in case of buybacks. So, the moment you buy stocks through the stock exchange, you are actually buying it from an existing shareholder and not directly from the company. The selling also happens to another investor and not to the company.

All about Share Prices and Supply and Demand

There are multiple factors affecting the prices of shares listed on a stock exchange. The most common is through the process of auction where buyers and sellers quote their bids and offers. Millions of investors with different mindsets influence the value of a stock. The stock exchange records the information through computer-generated algorithms.

The law of supply and demand work perfectly in real-time in a stock exchange. If a certain stock has more buyers than sellers, the price of the stock will increase. On the contrary, if the stock has more sellers than buyers, the price will decrease.

Matching Buyers and Sellers

Most stock markets have professional traders called market makers to keep the bids going. Matching buyers with sellers started off manually called open outcry. Verbal communication and hand signals were used to trade in stocks.

However, now the electronic trading system has taken over to do the job. It is far more efficient and much quicker than the manual process enabling lower trading costs. Trade execution is also much faster.

Let us chalk out the advantages and disadvantages of stock exchange listings.

Advantages of Stock Exchange Listings

  • Liquidity of shares are readily available for shareholders
  • Companies can raise funds by increasing the issue of shares
  • Publicly traded shares attract more talent and diligent employees
  • Companies listed on the stock exchange enjoy more visibility in the marketplace
  • Companies can use their listed shares as currency to make purchases

Disadvantages of Stock Exchange Listings

  • Significant costs are involved, including listing fees, compliance fees and other reporting costs
  • Stringent rules and regulations stifle a company’s ability to perform as expected
  • Short-term goals of investors force companies to take a hurried approach rather than concentrate on long-term goals

However, investing in stocks over longer periods generate higher returns compared to other asset classes. Shareholders enjoy capital gains and dividends from shares traded professionally over a period of time.

Stock Market and the Economy

The condition of the economy does influence the stock market scenario. If the economy is expanding, people will be willing to invest in stocks. That’s because companies can enhance their earnings while the economy is strong. This makes for what is called a bull market.

Investing in bonds is a safer option when the economy is dipping. Bonds give a fixed rate of income up to the maturity period. During this phase, stocks lose their value and, the phase is called the bear market.

Stock Market Correction

This happens when share prices drop by 10% or more. The pullback helps consolidate the market and encourages it to go much higher. It’s a part and parcel of every market cycle. In extreme cases, a stock market crash can occur where prices drop drastically in a single day. It can also lead to a recession since corporations raise funds by issuing stocks. Hence, a fall in stocks has a direct effect on the companies’ ability to grow. This, in turn, leads to lay off and unemployment sets in.

However, even during a crash, you should not sell your shares. This is because the stock markets will make up for the losses in a couple of months. By selling your shares during a crash, you miss out on time required to make up for the losses.