Lesson 8 of 8 · All lessons in this module
- What the financial system does, and what makes it work well
- Classifying assets and markets: securities, pooled vehicles, currencies, commodities and real assets
- Contracts: forwards, futures, swaps, options and insurance
- Financial intermediaries and the services they provide
- Long, short and leveraged positions: leverage ratio, margin return and margin callsVideo lesson
- Orders: execution, validity and clearing instructionsVideo lesson
- Integrated cases: a leveraged loss, a hedge with a floor and a stop-limit buy
- Primary markets, secondary markets and how trades are arranged
Free lesson: the first lesson of every module is open to everyone.
Lesson 8 of 8 · 15 min
Primary markets, secondary markets and how trades are arranged
Issuers sell new securities in the primary market and investors trade them in secondary markets, whose liquidity lowers issuers' cost of capital; secondary trading is organised as call or continuous sessions in quote-driven, order-driven or brokered markets.
In short
- IPO: first public sale of a security; seasoned (follow-on) offering: more of an already-issued security, normally new shares sold by the issuer. Both are primary market transactions.
- Underwritten offering: the bank guarantees the sale and buys unsold securities; best efforts: the bank acts only as broker. Underwriters' conflict of interest tends to underprice IPOs.
- Other routes: private placements, shelf registrations, dividend reinvestment plans, rights offerings, and government auctions.
- Liquid secondary markets let investors sell easily, so they pay more for new issues, lowering issuers' cost of capital.
- Call markets trade at set times (one uniform price); continuous markets trade any time. Quote-driven: trade with dealers; order-driven: rules match orders (price, display, time precedence); brokered: brokers find counterparties for unique assets.
Primary markets: public offerings
When issuers first sell securities to investors, the trade is in the primary market. An initial public offering (IPO), or placing, is the first public sale; selling more units of an existing (seasoned) security is a seasoned (follow-on) offering. Older texts call a follow-on by the issuer a 'secondary offering'; newer usage keeps primary follow-on for new, dilutive shares and secondary follow-on for existing shares sold by holders (non-dilutive, no proceeds to the issuer). Read the word in context. Later trading among investors happens in secondary markets.
Companies usually hire an investment bank to line up buyers, a process called book building (the London book builder is the book runner). Before the offer, the issuer discloses its business, risks and use of funds in detail. In Europe an accelerated book build done in a day or two, usually at a discount, is used when time matters. An IPO may include new shares from the company and existing shares sold by founders and early investors who want to cash out.
In an underwritten offering, the most common type, the bank guarantees the sale at the negotiated offering price and buys anything unsold. For IPOs it typically also makes a market for about a month to support liquidity and the price. Large issues use a syndicate, and fees are around 7%. In a best efforts offering the bank acts only as broker, so an undersubscribed issue simply sells less.
A price set too high leaves the offer undersubscribed; too low, oversubscribed, and shares are allocated to favoured clients or pro rata (Standard III(B) calls for a disclosed, fair allocation policy). Underwriters have a conflict of interest: as the issuer's agent they should maximise proceeds, but a low price lets them reward clients and avoid buying and supporting overpriced shares. So IPO prices tend to be low and often jump on the first day. First-time issuers accept this because an undersubscribed IPO signals bad news and makes later fundraising harder. The problem is smaller for seasoned offerings, where a market price already exists.
Other primary-market routes, and why secondary markets matter
A private placement sells securities directly to a small group of qualified investors with far less disclosure. It can be cheaper, but buyers demand higher returns (lower prices) because they cannot resell in an organised secondary market.
A shelf registration completes all disclosure up front but sells shares into the secondary market bit by bit when capital is needed, giving timing flexibility and less price pressure than one big offering. A dividend reinvestment plan (DRP/DRIP) issues new shares to holders who reinvest dividends, sometimes at a small discount. A rights offering gives existing holders rights, in proportion to their holdings, to buy new shares below market price; holders must exercise or sell the rights to avoid dilution, so they tend to dislike them. Analysts value the rights as short-term warrants.
Strong national governments usually sell bills, notes and bonds in public auctions (or directly to dealers); smaller or weaker governments often use investment banks, though many are required by law to auction.
Secondary markets support primary markets. In a liquid market investors can sell quickly with small price concessions, so they pay more for securities they can resell. Higher prices mean a lower cost of capital for issuers.
| Method | Who buys | Key feature |
|---|---|---|
| Underwritten offering | The public | Bank guarantees the sale and buys unsold securities |
| Best efforts offering | The public | Bank acts only as broker; issuer bears the risk of unsold securities |
| Private placement | Small group of qualified investors | Less disclosure; buyers demand higher returns |
| Shelf registration | Secondary market, over time | Full disclosure up front; issue as needed |
| Dividend reinvestment plan | Existing holders | Dividends reinvested in newly issued shares |
| Rights offering | Existing holders | Rights to buy below market; dilution if not used |
Trading sessions: call markets vs continuous markets
Trading is a two-sided search, and market structures exist to make it cheaper. In a call market, trades can be arranged only when the market is called at a set time; in a continuous market, any time it is open.
Call markets concentrate all orders at one moment, so they can be very liquid then, but they are completely illiquid between calls. Continuous markets let a willing buyer and seller trade at any time, but only if both are present at the same time.
Most call markets run a single-price auction: they build the buy and sell order books (effectively demand and supply schedules) and choose the one price that maximises the volume traded. Many continuous markets open with a call after a pre-opening period, and some close with one, where traders use market- or limit-on-close orders.
Execution mechanisms: quote-driven, order-driven and brokered
In quote-driven (price-driven, dealer, OTC) markets, customers trade at prices quoted by dealers. Most trading other than in stocks works this way: almost all bonds and currencies and most spot commodities. Trades now run over electronic networks, phone or messaging.
In order-driven markets, rules match buy and sell orders submitted by customers or dealers. Almost all exchanges and every automated system are order-driven. Because traders often deal with strangers, these markets need procedures that make everyone settle.
In brokered markets, brokers find counterparties for unique, rarely traded assets that dealers will not hold in inventory and that would draw too few orders for an order-driven market: large blocks of shares, real estate, art, intellectual property, whole companies, licences. Good brokers know everyone who might trade.
Many systems combine structures. Transparency matters too: a market is pre-trade transparent if it publishes quotes and orders in real time and post-trade transparent if it publishes trade prices and sizes soon after. Buy-side traders like transparency; dealers prefer opaque markets, where spreads and costs tend to be higher.
| Quote-driven | Order-driven | Brokered | |
|---|---|---|---|
| Who you trade with | A dealer | Whoever's order the rules match | A counterparty the broker finds |
| Liquidity from | Dealers | Other traders (public and dealers) | Broker's network |
| Typical instruments | Bonds, currencies, spot commodities | Exchange-listed shares, futures | Large blocks, real estate, art, companies |
Order-driven rules: matching and pricing
Order matching rules rank orders by an order precedence hierarchy: first price priority (highest buy, lowest sell), then display precedence (displayed size before hidden size at the same price), then time precedence (earliest first). This rewards improving the price, displaying size and arriving early, which all add liquidity. The top buy is matched with the top sell for the smaller quantity, and so on until no more trades are possible.
Trade pricing rules set the price. Call markets use the uniform pricing rule: everyone trades at the single volume-maximising price. Continuous markets use the discriminatory pricing rule: each trade executes at the limit price of the standing order. A large arriving order walks through the book, paying each standing order's price in turn.
Crossing networks use the derivative pricing rule: they match buyers and sellers at a price taken from another market, typically the midpoint of the main exchange's best bid and offer, independent of the orders submitted to the network.
Formulas
- Average fill price of an order
Quantity-weighted average of the prices at which each part filled (discriminatory pricing).
- First-day IPO return and placement cost
Placement cost measured against the new funds actually raised (net proceeds).
Worked examples
Example 1 An IPO's numbers
Fjellvind ASA sells 30 million shares at NOK 40 in its IPO: 10 million new shares from the company and 20 million from founders. The company's net proceeds are NOK 372 million. The shares close the first day at NOK 43. What were the company's gross proceeds, its placement cost as a percentage of net proceeds, and the first-day return?
Example 2 Call auction clearing price
At the opening call, cumulative buy orders willing to pay at least EUR 20.00, 20.10, 20.20, 20.30 and 20.40 are 1,000, 800, 600, 350 and 200 shares. Cumulative sell orders willing to accept at most those prices are 200, 400, 650, 800 and 1,000. At what price does the call trade, and how many shares?
Example 3 A large order in a continuous market
The book offers 200 shares at EUR 10.03, 600 at 10.05 and 500 at 10.08 (best bid 10.00). Ole sends a day order to buy 1,000 shares, limit 10.05. What fills, at what average price, and what happens to the rest? What if it were immediate-or-cancel?
On the exam
Expect classification of offering types (IPO, seasoned, private placement, rights, shelf), who bears the risk in underwritten vs best efforts deals, order precedence with hidden orders, and the average price of an order that walks the book.
- Calling a seasoned offering of new shares a secondary-market trade because some texts label it 'secondary'; it is a primary-market sale by the issuer. A sale of existing holders' shares is the non-dilutive 'secondary follow-on'.
- Saying the issuer bears unsold-share risk in an underwritten offering; the investment bank does.
- Ranking a hidden order ahead of a displayed one at the same price because it arrived earlier; display beats time.
- Pricing continuous-market fills at the arriving order's limit; they execute at the standing orders' prices.
Check yourself
Q1In an underwritten offering, the risk that the issue cannot be sold at the offering price is borne by the:
Q2A listed company gives existing shareholders the right to buy one new share at EUR 8 for every five held, while the shares trade at EUR 11. This is a:
Q3Liquid secondary markets most likely help issuers in primary markets by:
Q4An order-driven market allowing hidden orders has these sell orders: I at 15.20 (hidden, 10:01:00), II at 15.20 (displayed, 10:01:05), III at 15.18 (displayed, 10:02:30). Which order has the highest precedence?
Q5The book has buy orders of 300 at EUR 20.05, 500 at 20.00 and 400 at 19.90. A day order to sell 1,000 shares, limit 19.95, arrives. Its average sale price is closest to:
Q6Trades in a large block of a thinly traded private company's shares are most likely arranged in a(n):
Answer the 6 questions: +10 XP for each one you get right first time.
Liked this lesson? Get the rest free for 7 days
Create a free account to open the other 7 lessons in this module, with videos, flashcards that come back before you forget them, the question bank and full mocks. No card needed.