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Secondary Market Definition
A secondary market (also known as the aftermarket) is a type of financial market that facilitates the sale and purchase of previously-issued securities by investors. These securities are typically shares, bonds, investment notes, futures and options. All commodity markets as well as stock exchanges are classified as secondary markets.
A Little More on What is a Secondary Market
Secondary markets are most predominantly used to trade stocks. However, there are several other uses of such markets; for instance, secondary markets facilitate trading in mutual funds as well as mortgage purchases by government enterprises such as the Federal National Mortgage Association (popularly referred to as Fannie Mae) and the Federal Home Loan Mortgage Corporation (popularly referred to as Freddie Mac).
The term ‘secondary markets’ can also be used as a synonym for markets that facilitate trade in used goods. Moreover, in present times, the definition of a secondary market has expanded to include cryptocurrency exchanges. In the context of a security market though, a secondary market is thus named because they facilitate secondary transactions involving securities.
The Differences between Primary and Secondary Markets
A primary market is a financial market that facilitates the sale of a stock or a bond that has been issued by a company for the first time directly to the investors. A common example of a primary market transaction is an Initial Public Offering (IPO). An IPO involves a direct transaction between the seller, which is the investment bank underwriting the offering, and the buyer, who is the investor purchasing the IPO. Such an IPO transaction only occurs in the primary market.
In sharp contrast, a secondary market is a financial market that facilitates those transactions that occur between investors. For example, an investor that purchased a stake in a company through an IPO can choose to sell his holdings to other investors in a secondary market. It may be observed in the above example that neither the company that issued the IPO, nor the underwriting bank will receive any proceeds from the sale of a security in the secondary market.
Setting Prices in the Secondary Market
Unlike primary markets where the prices of tradable securities are often determined in advance, in a secondary market, prices are exposed to the basis market forces of supply and demand. For a stock that demonstrates a high potential for an increase in value in the future, its current market price will also increase. Conversely, if a company posts earnings that are well below investor estimates, it falls out of favor of investors, and as a result, its market price dwindles.
Private Equity Secondary Markets
Private equity secondary markets are financial markets that facilitate the sale and purchase of previously-issued investor commitments to private equity funds. The NASDAQ Private Market and SecondaryLink are examples of private equity secondary markets that emerged during the turn of this century as an aftermath of the Sarbanes-Oxley Act of 2002.
References for Secondary Market
Academic Research for Secondary Market
The impact of the secondary market on the supply chain, Lee, H., & Whang, S. (2002). Management science, 48(6), 719-731. This paper scrutinizes the effect of a secondary market on the supply chain. The authors construct a two-period model consisting of one manufacturer and several resellers. The first period involves resellers procuring products from the manufacturer. Then, as the second period commences, these resellers resort to a mutual trade of inventories in the secondary market. The paper obtains optimal decisions for the resellers and derives the equilibrium market price of that secondary market.
Secondary stock market performance of initial public offers, Hong Kong, Singapore and Malaysia: 1978–1984, Dawson, S. M. (1987). Journal of Business Finance & Accounting, 14(1), 65-76. This paper samples stock markets in Singapore, Malaysia and Hong Kong during the period 1978 – 1984, and analyzes the secondary market price performance of Initial Public Offerings (IPOs) there. The objective is to test secondary market pricing efficiency for IPOs. The author extends the evaluation of new issue price performance to secondary market trading over the course of the following year.
Determinants of secondary market prices for developing country syndicated loans, Boehmer, E., & Megginson, W. L. (1990).The Journal of Finance, 45(5), 1517-1540. This paper investigates the determinants of secondary market prices of syndicated loans for developing countries. Analysis of market prices in these markets for the period 1985 – 1988 reveals that trading volume has nearly doubled in this market. On the other hand, average market prices have shown a significant decline from 73% to 41% of par value during the sampled period. The authors deduce that it is a country’s solvency and not its liquidity that determine loan values.
The effect of the secondary market on the pricing of initial public offerings: Theory and evidence, Mauer, D. C., & Senbet, L. W. (1992). Journal of Financial and Quantitative Analysis, 27(1), 55-79. The authors perform a theoretical as well as an empirical analysis of the secondary market as a determinant of the pricing of initial public offerings. Their investigation reveals that the pricing of IPO offerings are highly influenced by limited investor access as well as a fragmentary spanning of the primary issues in the secondary market. The authors evaluate a price differential in the primary and secondary markets that is compatible with the preconceived idea of IPO underpricing.
Relicensing as a secondary market strategy, Oraiopoulos, N., Ferguson, M. E., & Toktay, L. B. (2012). Management Science, 58(5), 1022-1037. This paper seeks to explain how determinants such as relative competitive advantage, product characteristics, and consumer preferences affect the incentives and optimal strategies of an original equipment manufacturer (OEM) with respect to the secondary market. The authors scrutinize whether the indirect benefit derived from sustaining an active secondary market can compensate for the potentially negative consequence of product cannibalization.
Are banks still special when there is a secondary market for loans?, Gande, A., & Saunders, A. (2012). The Journal of Finance, 67(5), 1649-1684. Secondary market trading in loans brings forth a remarkable upward price reaction by the equity investors of a borrowing firm. The authors ascribe this to a noteworthy reduction in the financial constraints of the borrowing firm. Moreover, the report of a new loan sanction leads to a positive movement in stock price.
Who benefits from secondary market price stabilization of IOPs?, Benveniste, L. M., Erdal, S. M., & Wilhelm Jr, W. J. (1998). Journal of Banking & Finance, 22(6-8), 741-767. This paper scrutinizes IPOs that benefit from secondary market price support from underwriters. Such IPOs characteristically sell in large quantities, especially through institutional traders, while their small-quantity, retail sales figures are conspicuously tiny. Institutional trading is markedly high on the first day of trading while retail trading remains attenuated, which undermines the probability of retail investors receiving comparatively large initial allocations of stabilized offers.
Bank loan sales: A new look at the motivations for secondary market activity, Demsetz, R. S. (2000). Journal of Financial Research, 23(2), 197-222. The author employs a novel approach to test the viability of the following two hypotheses pertaining to the forces that drive loan sale and purchase decisions of banking institutions: The comparative advantage hypothesis, which states that banks that possess a comparative advantage in originating loans tend to sell loans. Similarly, banks with a comparative advantage in funding loans end up buying loans. The diversification hypothesis, which states that banks that lack the capability to diversify internally achieve diversification by way of loan sales as well as purchases.
The benefits of a secondary market for life insurance policies, Doherty, N. A., & Singer, H. J. (2003). Real Property, Probate and Trust Journal, 449-478. The authors undertake an analysis of the benefits offered by secondary markets to home mortgage and catastrophic risk insurance industries. The objective of this study is to evaluate the benefits of the active secondary market for life insurance policies to both policyholders as well as incumbent insurers in primary markets. The paper advocates the formulation of regulations that encourage participation and investment in this secondary market.
GSEs, mortgage rates, and secondary market activities, Lehnert, A., Passmore, W., & Sherlund, S. M. (2008). The Journal of Real Estate Finance and Economics, 36(3), 343-363. This paper analyzes samples of monthly data collected from secondary markets over the period 1993 – 2005. Based on the sampled data, the authors evaluate a Value at risk (VaR) model that demonstrates the correlation of GSE secondary market activities with mortgage interest rate spreads. They conclude that there exists no significant correlation of GSE portfolio purchases with either primary or secondary mortgage rate spreads. Moreover, GSE portfolio purchases also had negligible impacts on mortgage rates.