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FX101: Primary versus Secondary Markets

In Business and Currency by Continental StaffLeave a Comment

Securities, primary and secondary markets are all incredibly important concepts and entities in the world of investment and the global economy. But what are they and how do they function? In this post, we introduce you to this complex and oftentimes treacherous world with a breakdown of primary versus secondary markets, as well as a brief look at how they affect foreign exchange.

What are Securities?

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Before we begin any conversation regarding primary and secondary markets, we must first understand the concept of securities. A security is a piece of paper whose value can be expected to increase (or decrease) based on the level of profits enjoyed by the company (or other entity) of which the security represents a part. There are many different types of securities, although they can be divided into two basic categories: equities and debts.

What are Equities?

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An equity security, or stock, gives the buyer of that security an ownership share in the entity (either a company, partnership or trust) that issued the security. Equity securities entitle the holder to some control of the company, via voting rights, in proportion to the amount of securities they hold.

An equity security does not entitle its holder to regular payments, although dividend payments are often paid out. Instead, the equity-holder will be able to profit from any capital gains that have accrued once they sell the security. If a bankruptcy occurs, equity-holders will only share in any residual interest after any creditors have been repaid.

What are Debts?

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Debt securities, or bonds, give the holder loanership in the security, as opposed to ownership. In contrast to equities, which are regarded as a purchase, debt securities are viewed as loans, that must be repaid. When investing in a debt security, terms are set for the size of this loan, the amount of interest that will be paid for it, and the date of maturity, when the principal amount of the debt will be repaid to the investor.

The benefits of debt securities are that they pay regular interest, as well as the repayment of the full initial investment and any other stipulations that were set in the contract. Although debt – or bond – holders are not entitled to any voting rights, in the event of bankruptcy, they are usually a safer bet than equities for returning the investment to their holder.

There are quite a number of variations on the basic types of equity and debt securities, with hybrid securities existing as well. However, now that we have a basic understanding of what securities are, it’s time to turn to the markets.

What are Primary Markets?

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A primary capital market, simply stated, is the market for securities sold directly by a company or other entity to investors (although companies can also engage an underwriter to assume this responsibility as well). Companies sell these securities in order to fund improvements to their business or to expand their operations, as well as to spread the risk of ownership across a large swathe of investors. Indeed, the primary market can be an excellent tool by which companies can raise capital.

What are IPOs?

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Facebook Inc., Spotify, Visa are all excellent examples of this. With their Initial Public Offerings (IPOs), each of these companies was able to raise a vast amount of capital. Demand for new securities is incredibly uncertain, and prices for securities being sold on the primary market are usually set quite low. However, because every one of the aforementioned companies had a great degree of public brand awareness prior to going public, the prices for their securities ranged on the highside: from Visa’s 44US$/share in 2008, to Facebook’s 38US$/share in 2012 to Spotify’s 165.90US$/share in 2018.

Companies should exercise some caution before setting themselves on the path to an IPO. While many aspects can or ought to be healthy for a business: before an IPO can be held a company needs to open itself up to full transparency to regulators, there are also risks involved. The primary market is very volatile, but what can be even more dangerous for a company is opening itself up to a far greater extent to the whims and expectations of external stakeholders.

This danger can be greater the larger the success and size of the IPO. A leader and helmsman can very soon be forced into a position where they must sacrifice or compromise on their vision to keep their shareholders happy. When it comes to investors, large IPOs can turn out to be red herrings as well. As the old mantra goes: past performance is no indication of future profits; and on that note, we turn our attention to secondary markets.

What are Secondary Markets?

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Once all newly-issued securities have been sold to the public in an IPO, all further sales are conducted on the secondary market. Indeed, when it comes to most people’s perceptions of the stock market, it is the secondary market they have in mind. The New York Stock Exchange, NASDAQ, and the Toronto Stock Exchange are all well-known examples of secondary markets.

While bigger investors, such as banks and large institutional investment firms tend to buy securities directly on the primary market (and are often actively courted by companies to do so), the secondary market is by and large dominated by individual investors with much smaller amounts of funds at their disposal. The secondary market is very much the domain of laymen then. For although investors on the secondary market use brokers to make their purchases, the securities available on the secondary market are open to everyone, and small transactions are as much accepted as large ones. The price of securities fluctuates on a daily basis, but these are no longer directly influenced by the IPO, and as such can be said to more accurately represent the actual value of the security.

How Does Forex Fit In?

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But how do primary and secondary markets affect foreign exchange, and how does the foreign exchange market affect the market for securities? It’s not actually entirely clear, and even experts have trouble with this point.

In theory, when a nation’s primary/secondary markets are doing well, confidence in that nation will increase leading to increased foreign investment, leading to an increased demand for that currency followed by a subsequent rise in the value of that currency. When a nation’s securities markets are in decline, by the same logic, there will be less foreign investment and subsequently lower demand for that currency, resulting in a decrease in the currency’s value.

In practice, however, while this correlation does sometimes function much as was just stated – the key word is sometimes. It is by no means consistent. A look at the relationship between the US dollar and the S&P 500 index over the past 20 years clearly illustrates this point, as they have moved at varying points both in unison, opposingly, and sometimes their movements have born no influence on each other at all.  

Still, this doesn’t mean that the theory is bust. It just means one needs to know when the theory is working in practice, and when it’s not. A skill that only comes with years of study and observation of the markets.

Conclusion

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The primary market is mostly confined to companies and large investment bodies, and as such does not lend itself so well to individual investors looking to benefit their portfolio. However, what happens on the primary market should certainly be of interest and monitored by anyone interested in investment. While the results of an IPO do not necessarily indicate whether a security will do well or poorly long-term, they can offer positive prospects and exciting new opportunities for investors on the secondary market.

Although public action on the primary market is oftentimes confined to bigger players, the secondary market is definitely an everyman’s game. There are no real limits to the size of transactions conducted, meaning even those individuals with modest means can try their hand at investment. While price and demand shift daily on the secondary market, it can still be less volatile than the fluctuations and dynamics of the primary market. For the average person, therefore, while an understanding of both markets is certainly an asset, the secondary market is the domain that bears most promise for active involvement.

Learn more about international finance and foreign exchange with the rest of our FX101’s!

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