Question

Explain the difference between primary and secondary markets and why secondary markets are so important to businesses that need to raise capital?

Give examples from the real world?

Answer 1

The primary market is that segment of capital market wherein the companies directly issue bonds or stocks to the investors. Thus it comprises of sellers as the companies which tries to raise money by selling securities and the buyers are the investors who invest money in those companies through purchase of bonds or stocks.

The secondary market provides liquidity to the system and comprises of investors trading these securities among themselves. Through this trading of securities, the price discovery of these securities happen in a transparent manner which leads to efficient allocation of capital and determination of value of businesses.

Due to the fact that secondary market exists and an investor is able to sell a stock or a bond in the secondary market, it becomes easier for the company issuing these stocks or bonds to offer them in the primary market without conceding a disproportionate liquidity premium and also the company is able to get a fair indication of its cost of capital.

For example, if a company XYZ wants to issue shares to fund its growth and in the absence of a secondary market, it would find very less takers or it would have to sell stocks at a low price to ensure that new investor buy those stocks. But in the presence of a secondary market, wherein frequent trading of its stocks are being done, XYZ already has a fair idea of the price of the stock and thus could sell its stock at a fair price and get adequate money to invest in the new projects.