2-Financial Markets Page 27 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 27the amount and the likelihood of the cash flow expected to be gener-
ated. In an efficient market, prices reflect the aggregate information col-
lected by all market participants.Secondary Markets
The secondary market is where already-issued financial assets are
traded. The key distinction between a primary market and a secondary
market is that in the secondary market the issuer of the asset does not
receive funds from the buyer. Rather, the existing issue changes hands in
the secondary market, and funds flow from the buyer of the asset to the
seller. Below we explain the various features of secondary markets.
These features are common to any type of financial instrument traded.
It is in the secondary market where an issuer of securities, whether
the issuer is a corporation or a governmental unit, may be provided
with regular information about the value of the security. The periodic
trading of the asset reveals to the issuer the consensus price that the
asset commands in an open market. Thus, firms can discover what value
investors attach to their stocks, and firms and noncorporate issuers can
observe the prices of their bonds and the implied interest rates investors
expect and demand from them. Such information helps issuers assess
how well they are using the funds acquired from earlier primary market
activities, and it also indicates how receptive investors would be to new
offerings.
The other service a secondary market offers issuers is that it pro-
vides the opportunity for the original buyers of the asset to reverse their
investment by selling it for cash. Unless investors are confident that they
can shift from one financial asset to another as they may deem neces-
sary, they would naturally be reluctant to buy any financial asset. Such
reluctance would harm potential issuers in one of two ways: either issu-
ers would be unable to sell new securities at all or they would have to
pay a high rate of return, as investors would demand greater compensa-
tion for the expected illiquidity of the securities.
Investors in financial assets receive several benefits from a secondary
market. Such a market obviously offers them liquidity for their assets as
well as information about the assets’ fair or consensus values. Further,
secondary markets bring together many interested parties and so can
reduce the costs of searching for likely buyers and sellers of assets.
Moreover, by accommodating many trades, secondary markets keep the
cost of transactions low. By keeping the costs of both searching and
transacting low, secondary markets encourage investors to purchase
financial assets.