Chapter 9 • The secondary capital market and its efficiency
course, competing with each other for investors’ business. Those giving the best ser-
vice, in terms of advice and guidance, are likely to attract most dealing commissions.Derivatives
Not only can investors buy and sell securities, they may also buy and sell derivatives
linked to security prices. Investors may, for example, buy and sell security options.
They can buy the right (but not the obligation) to buy or sell specified securities at pre-
determined prices before a stated date. If, for example, an investor believes that
Vodafone Group plc’sshares are due to rise in price, an option to buy a certain quant-
ity at a specified price before a stated date can be bought. This would be known as a
‘call’ option, and the price of such an option would depend on the quantity, the call
price and the exercise date. If, by the exercise date, the market price of Vodafone
Group shares were above the call price, the investor would take up the option to buy
the shares. An option giving the right to sell is known as a ‘put’ option. In certain secur-
ities the option itself may even be bought and sold (traded options). Share options are
another example of derivatives (see Chapter 1), and just one of many derivatives
linked to security prices.The place of the LSE in the UK secondary market
There is no legal requirement in the UK that all secondary market activities must be
carried out through the LSE. While it has long been and still remains the case that the
LSE dominates the UK secondary market in terms of business transacted, there are
other markets, albeit limited ones.
There are, for example, commercial organisations that operate over-the-counter
(OTC) markets, where the organisations act as market makers in a range of securities.
Securities are bought from and sold to the investing public, in much the same way
as second-hand furniture is bought and sold by dealers, without an agent being
involved.
There is some evidence – for example, the emergence of the OTC market – that
suggests that members of the investing public will readily look elsewhere if they
feel that the LSE is not providing the service they need, at a price they are prepared
to pay.9.3 Capital market efficiency
When security prices at all times rationally reflect all available, relevant information,
the market in which they are traded is said to be efficient. This implies that any new
information coming to light that bears on a particular business will be incorporated
into the market price of the security quickly, and rationally in terms of size and direc-
tion of security price movement.
To say that a secondary capital market is efficient is not necessarily to imply that the
market is ‘perfect’ in the economists’ sense, although to be efficient the market has to
display most of the features of the perfect market to some degree. It is also important
to note that efficiency does not mean perfect powers of prediction on the part of
investors. All it means is that the current price of a security is the best estimate of
its economic value on the basis of the available evidence. Note that ‘efficient’ in the