POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

College of Accountancy and Finance

Department of Financial Management
Sta. Mesa, Manila

Week 7 – 8: Secondary Market

Discussion: There will be five (5) parts of the discussion that we need to tackle:

1. Recognize the importance of secondary market

2. Discuss the features of the secondary market
3. Differentiate the instruments traded
4. Identify the market players
5. Explain the trading process

Definition & Features

The secondary market is the forum in which older or seasoned bonds change hands
between investors and dealers. Although most individuals are buy‐and‐hold investors,
institutional customers such as mutual funds, money managers, and insurance companies are
more active buyers and sellers.

It is what most people typically think of as the "stock market," though stocks are also
sold on the primary market when they are first issued. The national exchanges, such as the
New York Stock Exchange (NYSE) and the NASDAQ, are secondary markets.

Securities issued by a company for the first time are offered to the public in the primary
market. Once the IPO is done and the stock is listed, they are traded in the secondary market.
The main difference between the two is that in the primary market, an investor gets securities
directly from the company through IPOs, while in the secondary market, one purchases
securities from other investors willing to sell the same.

The secondary market is important for several reasons:

 The secondary market helps measure the economic condition of a country. The rise or
fall in share prices indicates a boom or recession cycle in an economy.
 The secondary market provides a good mechanism for a fair valuation of a company.
 The secondary market helps drive the price of securities towards their genuine, fair
market value through the basic economic forces of supply and demand.
 The secondary market promotes economic efficiency. Each sale of a security involves
a seller who values the security less than the price and a buyer who values the security
more than the price.

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 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
College of Accountancy and Finance
Department of Financial Management
Sta. Mesa, Manila

 The secondary market allows for high liquidity – stocks can be easily bought and sold
for cash.

Functions

 A stock exchange provides a platform to investors to enter into a trading transaction of

bonds, shares, debentures, and such other financial instruments.
 Transactions can be entered into at any time, and the market allows for active trading
so that there can be immediate purchase or selling with little variation in price among
different transactions. Also, there is continuity in trading, which increases the liquidity
of assets that are traded in this market.
 Investors find a proper platform, such as an organized exchange to liquidate the
holdings. The securities that they hold can be sold in various stock exchanges.

 A secondary market acts as a medium of determining the pricing of assets in a

transaction consistent with the demand and supply. The information about transactions
price is within the public domain that enables investors to decide accordingly.
 It is indicative of a nation’s economy as well, and also serves as a link between savings
and investment. As in, savings are mobilised via investments by way of securities.

Instruments Traded

The instruments traded in a secondary market consist of fixed income instruments,

variable income instruments, and hybrid instruments.

Fixed income instruments

Fixed income instruments are primarily debt instruments ensuring a regular form of
payment such as interests, and the principal is repaid on maturity. Examples of fixed income
securities are – debentures, bonds, and preference shares.

Debentures are unsecured debt instruments, i.e., not secured by collateral. Returns
generated from debentures are thus dependent on the issuer’s credibility.

As for bonds, they are essentially a contract between two parties, whereby a
government or company issues these financial instruments. As investors buy these bonds, it

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 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
College of Accountancy and Finance
Department of Financial Management
Sta. Mesa, Manila

allows the issuing entity to secure a large amount of funds this way. Investors are paid interests
at fixed intervals, and the principal is repaid on maturity.

Individuals owning preference shares in a company receive dividends before payment

to equity shareholders. If a company faces bankruptcy, preference shareholders have the right
to be paid before other shareholders.

Variable income instruments

Investment in variable income instruments generates an effective rate of return to the

investor, and various market factors determine the quantum of such return. These securities
expose investors to higher risks as well as higher rewards. Examples of variable income
instruments are – equity and derivatives.

Equity shares are instruments that allow a company to raise finance. Also, investors
holding equity shares have a claim over net profits of a company along with its assets if it goes
into liquidation.

As for derivatives, they are a contractual obligation between two different parties
involving pay-off for stipulated performance.

Hybrid instruments

Two or more different financial instruments are combined to form hybrid instruments.
Convertible debentures serve as an example of hybrid instruments.

Convertible debentures are available as a loan or debt securities which may be

converted into equity shares after a predetermined period.

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 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
College of Accountancy and Finance
Department of Financial Management
Sta. Mesa, Manila

Players of Secondary Market

The participants in the secondary equity market are:

Members of the Exchange (Stockbrokers)

The stockbrokers (broker-dealers) are the obvious participants. They are the members
of the exchange and facilitate transactions between the principals. However, as we noted, the
members are able to choose their dealing capacity, i.e., agent or principal (single capacity) or
both (dual capacity). In many markets of the world some members themselves are also
speculators in shares; in fact, there are some members that speculate only (i.e., have no
clients).

Ultimate Borrowers: Corporate Sector

As is well know by now, the only issuers of equity are corporate entities that have a
share capital. However, the corporate entities that have listed their shares on the exchange
also have a role in the secondary market, albeit a small one. This is to the extent that they
repurchase their shares. In most countries the law allows companies to repurchase their
shares under certain conditions. These shares are held as "treasury shares / stock" and may
be sold (i.e., issued) again. This will of course only occur when it is propitious to do so.

Financial Intermediaries

The Contractual Intermediaries (CIs), specifically the retirement funds and insurers,
the Collective Investment Schemes (CISs) (specifically the securities unit trusts) and some
hedge funds are the largest holders of equities. As such, they are also the largest participants
in the secondary market. These intermediaries are active in the market as buyers of equities
as they acquire funds for investment and also as buyers and sellers as they change the nature
and size of their equity portfolios in response the changing market conditions.

The banks are also holders of equity, but the amount is relatively small; most banks
hold shares opportunistically.

Ultimate Lenders

The ultimate lenders are made up of the four broad sectors of the economy: the
household, corporate, government and foreign sectors. The government is a small holder of
equities (listed and unlisted equities in public enterprises). The other three sectors are
sometimes large holders of equities.

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 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
College of Accountancy and Finance
Department of Financial Management
Sta. Mesa, Manila

The foreign sector is a considerable participant in the equity markets of some countries
as both a buyer and a seller. The sovereign funds (i.e., funds of countries - either the central
bank or government) are a prime example.

The corporate sector is a large holder of equity, both in the form of investments in
subsidiaries and in the form of "normal" investments. As such they are active in the secondary
market.

The household sector is of course comprised of individuals, and they are large holders
of equity. They either manage their own portfolios or outsource this function to stockbrokers
or to professional fund managers. As large holders, individuals are large participants in the
secondary market as they change the nature and size of their portfolios in response to
changing market conditions and expectations.

Fund Managers

The fund managers are the largest participants in the equity market - not as principals,
but as managers of the funds of principals. The principals that outsource their fund
management requirements are the securities trusts, the majority of insurers and retirement
funds and certain individuals.

Speculators and Arbitrageurs

Speculators and arbitrageurs are important participants on the equity market in that
they add "liquidity" to the market and thereby add to pricing efficiency. Speculators and
arbitrageurs do not constitute a separate group of participants; they are part of the categories
mentioned above. For example, certain financial intermediaries, such as banks and hedge
funds, fall into this category, as do certain retirement funds and securities unit trusts.

Arbitrage is usually defined as the seeking and taking advantage of price anomalies in
the same security in different markets, for example the spot equity and the equity futures
markets. An arbitrageur may also find an anomaly between the price of a share quoted on
both the local market and the London Stock Exchange, buy the share on the one exchange
and sell it on the other, and profit from the difference in price.

Speculators actively seek capital gain opportunities and undervaluation / overvalued

opportunities and take advantage of these by taking "positions" in equities.

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 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
College of Accountancy and Finance
Department of Financial Management
Sta. Mesa, Manila

Trading Process

Secondary markets are primarily of two types – Stock exchanges and over-the-counter
markets.

1. Stock Exchange

Stock exchanges are centralized platforms where securities trading take place, sans
any contact between the buyer and the seller. National Stock Exchange (NSE) and Bombay
Stock Exchange (BSE) are examples of such platforms.

Transactions in stock exchanges are subjected to stringent regulations in securities

trading. A stock exchange itself acts as a guarantor, and the counterparty risk is almost non-
existent. Such a safety net is obtained via a higher transaction cost being levied on
investments in the form of commission and exchange fees.

2. Over the counter (OTC) market

Over-the-counter markets are decentralized, comprising participants engaging in

trading among themselves. OTC markets retain higher counterparty risks in the absence of
regulatory oversight, with the parties directly dealing with each other. Foreign exchange
market (FOREX) is an example of an over-the-counter market.

In an OTC market, there exists tremendous competition in acquiring higher volume.

Due to this factor, the securities’ price differs from one seller to another.

Apart from the stock exchange and OTC market, other types of secondary market
include auction market and dealer market.

The former is essentially a platform for buyers and sellers to arrive at an understanding
of the rate at which the securities are to be traded. The information related to pricing is put out
in the public domain, including the bidding price of the offer.

Dealer market is another type of secondary market in which various dealers indicate
prices of specific securities for a transaction. Foreign exchange trade and bonds are traded
primarily in a dealer market.

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