The capital market is a platform where buyers and sellers trade various financial instruments such as bonds, stocks, and other securities. It is a medium for transferring capital from investors to companies that need the money to finance business ventures and investments. The term ‘capital market’ includes in-person and digital trading spaces with further classification into primary and secondary markets.
Here’s an in-depth look into the primary market v/s secondary market differences and their meaning. However, it is pertinent to understand the types of securities that investors encounter in capital markets before discussing primary and secondary markets. Let us have a look at that first.
Capital markets primarily deal with equities and debt securities. Both equity and debt securities are forms of investments with different risks and returns for the investor. Here’s a more detailed explanation of the two:
Although equity shareholders may profit from capital gains when they sell the securities, they may not receive regular payments. However, equity shareholders get some degree of control over the company via voting rights. Moreover, they get a share of the residual interest incase of bankruptcy. An equity security is traded on the stock market and represents the ownership interest of shareholders in a company or business venture. Equity securities translate to shares of capital stock, including shares of common and preferred stocks. Holding equity shares of a company means owning a portion of that company, and the shareholder is entitled to the company’s future earnings.
Some examples of debt securities include fixed deposits, certificates of deposits, government and corporate bonds, and collateralised securities. Unlike equity securities, debt securities entitle the lender to receive a stream of interest payments and other contractual rights, except voting rights, while requiring the borrower to repay the principal amount borrowed too. These are IOUs in the form of bonds and notes and represent the borrowed money that must be paid back with interest. Debt securities typically have specific terms stipulating the loan size, interest rate, debt maturity, and the renewal date.
Now that we have a better understanding of the two kinds of securities, let us look into the two capital markets – the primary and the secondary market.
Capital market transactions take place through primary markets and secondary markets. In other words, investors can buy and sell securities in two types of markets.
The primary capital market is where a company sells new bonds and stocks to the public for the first time. The initial public offerings – or IPOs – take place in the primary market.
The company that issues securities hires underwriters who help them correctly price their securities, buy those securities from them (which ensures all of their stock offerings are taken up), and then further sell them using their underwriting network. Say the underwriters, also known as book-running lead managers, determine the issue price of the stock at Rs. 100. Thus, investors in a primary market can buy the shares of the IPO at Rs. 100 directly from the issuing company. Any shares that are left in the market are purchased by the underwriters, thereby transferring the risk of buying the securities onto them.
The term primary market stems from the fact that investors can first-hand contribute capital to the company by purchasing the stock.
If a primary market creates securities, a secondary market is where the securities’ trading occurs. Popularly known as the stock market, the secondary market includes the BSE, NSE, NYSE, NASDAQ, and all stock exchanges around the world.
Investors trade previously issued securities in a secondary market, but these transactions do not involve the issuing company. For example, if you buy a stock of Tata Consultancy Services (TCS), you are dealing only with another investor who owns shares in TCS. However, TCS has no direct involvement in this transaction.
Once the issuing company issues security and underwriters determine its value, it is ready to sell in the primary market. Investors have four options to buy securities through the primary market:
- As explained before, an IPO or initial public offering is when a company makes its shares publicly available for the first time. While an IPO is a great way to raise capital quickly, it has its risks. If the company performs well, investors can expect solid returns. On the contrary, a struggling company would see share prices dropping below the offer price and investors taking a loss.
- A private placement is when a company sells its equity to a limited group of investors as bonds, stocks, or other securities. The company decides who they want to place their equity with. A private placement is different from an IPO since the former is not a public offering. Moreover, private placements typically have fewer regulatory requirements than an IPO.
- Like private placement, preferential allotment refers to the selective allotment of shares/securities to an exclusive group of investors. The investors need not be connected to the company or be its shareholders to get preferential allotment. However, companies can control the transfer of shares/securities to other investors.
A rights issue or rights offering is when a company issues a fresh batch of shares and invites its existing shareholders to buy them at a specified price. Thus, the existing shareholders enjoy the right to subscribe to those shares before they are offered to the general public. In case the shareholders reject the offer, the shares are issued in the primary market.
The secondary market has two specific categories: auction markets and dealer markets.
In an auction market, individuals and institutions, who are the buyers and sellers of the securities, simultaneously declare the price at which they are willing to trade. s The price at which the buyers are willing to buy the security is popularly known as the bid price, and the price at which the sellers are ready to sell the security is known as the ask price. The trade takes place when both parties agree on the same price.
A dealer market does not require the collective presence of trading parties but connects them through electronic networks. Dealers hold security inventory and post the prices they are willing to buy or sell a specific security. Competition between dealers provides the best possible price for investors.
Wrapping up, let’s outline the key differences between a primary and secondary market in the capital markets:
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While both the primary and secondary markets fall under the overarching term ‘capital market,’ the two are starkly different. On the one hand, a primary market is where companies directly sell new securities to investors. On the other hand, a secondary market deals in securities already issued by a company. Knowledge of how the primary and secondary markets work is crucial if you are new to capital markets. Investing in stocks can be a great way to maximise your wealth. Read 8 mind-blowing reasons/facts that prove the on the Teji Mandi blog.