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All You Need to Know About Primary and Secondary Markets

The stock market has two segments known as the primary market and the secondary market.

The primary market is where the securities are created.

The secondary market is where they are traded.

Let us understand these terms one at a time.

What is a Primary Market?

The primary market is where securities are first sold by the issuer and bought by investors, before they become available for trading on the bourses.

The primary market is where companies issue new securities which are not previously traded on any exchange.

It enables the government, companies, and other institutions to raise funds via the sale of equity and debt securities.

There are three entities involved in the functions of the primary market:

  • A company
  • An underwriter
  • Investors

The company issues securities for the first time.

The underwriter decides the sale price of the new issue of securities.

Lastly, investors are the buyers of the new securities.

Examples of some primary market securities are notes, bills, government bonds, corporate bonds, and shares of companies.

Let us look at the various types of primary instruments in detail.

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Examples of Primary Markets Issues

Initial Public Offer (IPO)

IPO is one of the most well-known routes for raising money in the primary markets. It is used by companies.

Initial public offering (IPO) is the process by which a private company goes public by the sale of its stock to general public.

Companies can raise equity capital with the help of an IPO by issuing new shares to the public.

Existing shareholders can also sell their shares to the public without raising any fresh capital for the company.

Preferential Issue

When a company issues shares to a few individuals at a price that may or may not be related to the market price, it is termed as a preferential allotment. This type of issue is one of the quickest methods for a company to raise capital.

In a preferential allotment, the preference shareholders receive dividends before the ordinary shareholders. The company decides the basis of allotment and it is not dependent on pro-rata or any such mechanism.

Rights Issue

In a rights issue, a company raises more capital from the existing shareholders by offering more shares at a price discounted from the prevailing market price. Investors have a choice of buying these shares at a discounted price within a specific period.

Bonus Issue

In a bonus issue, the company issues fully paid additional shares to its existing shareholders for free. These shares are a bonus for its current shareholders. The issuance of bonus shares does not require fresh capital.

Qualified Institutional Placement

Qualified Institutional Placement (QIP) is a fundraising tool, whereby a company raises capital by issuing equity shares, fully and partly convertible debentures, or any securities, other than warrants which are convertible to equity shares.

The only parties eligible to purchase QIPs are Qualified Institutional Buyers (QIBs). These are accredited investors, as defined by the market regulator.

Some of the QIBs are alternate investment funds, venture capital investors, mutual funds, pension funds, and scheduled commercial banks.

Why Does a Company Issue Securities in Primary Markets?

Companies issue securities in the primary market to raise money for business expansion, business development, improving infrastructure, repaying its debt, and many more reasons.

The primary source of funds is taking loans from banks. However, when a company raises funds from banks, it needs to pay interest to them.

On the other hand, when a company raises funds from the public via the primary market, there is no commitment to an interest payout. The company pays profits to the shareholders in the form of dividends or bonus. Shareholders also get rewarded if the equity share price of the company appreciates.

With that, let us now take a look at the secondary markets...

What is a Secondary Market?

Secondary market is where stocks and bonds, issued previously, are bought, and sold.

Simply put, in the secondary market securities are traded after they are initially offered in the primary market.

The Bombay Stock Exchange (BSE), National Stock Exchange (NSE) as well as all other stock exchanges as well as the bond markets, are secondary markets.

Securities issued by a company for the first time are offered to the public in the primary market. Once the security is listed on the exchanges, they become available for trading in the secondary market.

The main difference between the two is that in a primary market, an investor gets securities directly from the company through IPOs, while in the secondary market, investors buy securities from other investors who are willing to sell the same.

In the secondary market the company's share price is determined on the basis of demand and supply. In a primary market, the price of the security is fixed from the beginning whereas in the secondary market, the price levels varies with changes in demand and supply.

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Examples of Secondary Market

Stock Exchanges

Stock exchanges are centralised platforms where trading take place between the buyer and the seller. Bombay Stock Exchange (BSE), National Stock Exchange (NSE), and New York Stock Exchange (NYSE) are examples of such platforms.

Here, the exchange is responsible for being the intermediary that connects buyers and sellers. As a result, counterparty risk is almost zero as the exchange is a guarantor.

Over the Counter Market

Over the counter (OTC) market refers to the process where securities are traded in an informal way. OTC market is a decentralised market, comprising participants engaging in trading among themselves.

OTC market includes the securities that didn't fulfill the requirements to have a listing on the stock exchanges. It is a bilateral contract where two parties are involved i.e. the investor and dealer.

Stocks traded in OTC market are basically of smaller companies that cannot meet exchange requirements for formal exchange.

Here, the risk becomes higher in the absence of regulatory oversight. The price of securities may also differ from one seller to another as there is intense competition in acquiring higher volume.

Foreign exchange market (FOREX) is an example of an over-the-counter market.

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

Auction Market

Auction market is 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

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.

Importance of Primary and Secondary Markets

Primary markets are new markets, and secondary markets are resale markets. Understanding how these markets function gives investors better awareness on where to find which security.

Both the financial markets play a major role in the mobilisation of funds for companies that help move the wheels of the economy.

The stock market affects individual businesses in an economy in many different ways.

This is because an economy and its stock market are basically aligned. When the stock market is performing well, it is usually a function of a growing economy.

When the economy is growing, individual businesses produce more and usually expand.

In a market economy, the role of the capital market is of utmost importance.

A well-functioning capital market is vital in a modern economy to be perform an efficient transfer of resources from those who save towards those who need capital.

Here are Links to Some Very Insightful Equitymaster Articles and Videos Related to Primary and Secondary Markets...

Happy investing!