SECONDARY MARKET

MAKING
 SECONDARY MARKET
MAKING
∙ Secondary market is the market in which previously issued securities
trade among
1) investors and
2) between investors and dealers.

∙ The broker-dealer activities of investment banks and other securities

firms in the secondary market give financial claims greater liquidity.

∙ The existence of secondary market provides investors with an “escape

plan”, reduces cost of financing for the issuer (by ensuring liquidity)
and creates a source of revenue for the investment bank (from dealer
spreads and broker commissions)
 Dealing versus Brokering

Dealer Broker

Transacts (buys and sells) securities Transacts (buys and sells) securities
on his/her own account. Thus, is a on behalf of a client. Thus, is an
principal to a transaction. agent to a transaction.
Source of earnings is the spread Source of earnings is commission
between the buying price (bid price) for the transaction.
and selling price (ask price). That is
the bid-ask spread/margin.
Is exposed to price risk (risk that Is not exposed to any price risk.
the price of securities held in
inventory might decline)
 Dealing versus Brokering
∙ The risk of changing the price of his securities holding
is called the price risk.

∙ A broker in securities is not a principal, rather an agent

of the customers and gets commission on the
transactions.

∙ A dealer is the principal in the transaction and as a

result he does not earn commission for his own role.
 Dealer Activity in the Financial
Market
∙ There are some securities that are only traded
in the over-the counter market. These
markets are called dealer market.
Examples – Swaps, mortgage-backed products,
OTC options and guaranteed investment
contracts.
- However, there are some securities that are
traded both in the exchange and in the dealer
market. For example – stocks and bonds.
 Dealer Activity in the Financial
Market
Securities in the Formal Market & Dealer Market:
∙ An exchange is an organized, centrally located
marketplace that lists specific instruments. It is a
formal market subject to strict rules and regulations.
- These instruments are highly standardized.
- The rules for listing on the exchange are stringent.

∙ The dealer market is considerably less formal and

much more decentralized than an exchange market.
Why Investment Banks Participate
in the Secondary Market
a. To earn profit
b. To develop and maintain good pricing skills.
This in turn assists it in its primary market
making activity while valuing an IPO or
seasoned offering.
c. To create liquid markets for their securities.
- make secondary market for the underwritten
securities.
- make stabilizing bid for a new offering.
 Managing Dealer Risks
∙ Dealers earn their profits from the bid-ask spreads. Dealers
are not speculators.
∙ Speculators take positions (buy or sell securities) based on
their price forecasts (view).
∙ Dealers ideally want to have “Zero” net position. However,
this is rarely possible as buying and selling decision from
investors are not coordinated and dealers must offer
buy-sell bid. Thus, dealers are exposed to price risks.
∙ Price risk refers to the possibility that the holder of a
position will experience an unexpected change in the value
of the position as a consequence of a change in the price
level.
 Managing Dealer Risks
∙ Consequently, Managing the price risk is
very crucial for a dealer. Managing price
risk involves three steps:

a. Identify the risks;

b. Quantify the risks; and
c. Manage the risks.
 Step 1: Identifying risks
∙ The first step is to identify all risks to which
a dealer is exposed from holding a particular
security.

∙ The change in stock price may be due to -

- the change in economic fundamentals or
changes in the overall market (systematic
risk) or due to company or industry specific
factors (unsystematic risk).
 Step 1: Identifying risks
∙ In case of fixed income securities (bonds), risks
are more complicated.
These risks are:
a. Interest rate risk: It is the sensitivity of the prices
of fixed income securities to changes in interest
rate levels. In other words, risk of price of bond
declining due to rise in interest rate in the market.
b. Credit risk: It is the risk that issuers credit
worthiness may deteriorate. In other words, risk of
bond issuer not being able to service its promised
coupon payments and principal repayment.
 Step 1: Identifying risks

c. Call risk: It is the risk that the issuer may

choose to retire the issue prior to maturity. A
call usually results in investors receiving less
than envisioned YTM.

d. Prepayment risk: It is risk of early repayment

in case of mortgaged-backed securities.
 Step 1: Identifying risks
e. Purchasing power risk: It is the risk of loosing the
purchasing power as a consequence of inflation.

f. Tax rate risk: It is the risk that the tax treatment of an

issue might change due to a change in the tax law or
an unfavorable ruling by the tax courts.

∙ The degree to risk to a dealer depends on the type of

fixed income securities. i.e T-bills have little credit
risk compared to junk bonds. Non-callable bond has
no call risk etc.
 Step 2: Quantifying risk
∙ Once identified and before risks can be managed, they must be
quantified.
∙ This is important because often risks associated with one
position and the risks associated with another position may be
partially offsetting. This is called natural hedging.

∙ Systematic risk is usually measured using beta; a measure of

the co-movement of an individual securities return with the
return of the market.

∙ Unsystematic risk can be measured using standard deviation of

return of a security or a portfolio.
 Step 3: Managing Risks
∙ If dealer deals with a single stock, there is considerable company-specific
risk (unsystematic risk).

∙ It is possible to hedge this company specific risk with an option on the

stock if :
(1) there is an option on the stock that is currently trading, and
(2) the option market is sufficiently liquid that the cost of transacting the
option hedge does not cut too deeply into the dealer’s market-making
profit.

i.e a dealer with a long position in a security is wary of the possibility of a fall in
price of the security. Then the dealer can go long in a put option on that
security thereby locking in a sales price. If the price of the stock falls
below the option strike price then the dealer will exercise the put thereby
minimizing risk.
 Step 3:Managing Dealer Risks
• As an alternative, and generally superior, approach is to
deal in many stocks, which will eliminate the unsystematic
risk.

• In other words, diversify the portfolio with multiple

securities having less than perfectly positive correlation
with each other.

• The lower the correlation among the securities in the

portfolio, the less will the risk be (standard deviation will
fall).
 Step 3: Managing Dealer Risks
∙ For hedging the systematic risk:
a. Estimate the weighted average beta of the
portfolio;
b. Select the hedging instrument (such as S&P 500
futures contract or any other index future);
c. Determine the size of hedge.
 Step 3: Managing Dealer Risks
The portfolio beta serves as the hedge ratio.

A hedge ratio is the number of units of the

hedging instrument needed to offset the risks
associated with one unit of cash position.

Size of Hedge = Hedge Ratio X Size of Position

 Example
• A dealer has total open position in portfolio of
securities worth $ 22.5 million. The portfolio beta
is 1.25. Dealer has chosen S&P 500 futures
contract as the hedging instrument. One
contract/lot includes 500 futures with each future
priced at $420. What is the size of the hedge? How
many futures contract will have to be bought to
hedge the price risk of the dealer?
 Answer
a) Size of Hedge = Hedge Ratio X Size of Position
= 1.25 x 22,500,000
= 28,125,000

b) The total value of each futures contract is:

= price of each futures x no. of futures in one contract
= 420 x 500
= 210000
 Answer
Determine the number of future contract
necessary to hedge the dealer’s overall cash
position.

So, the risk manager of the dealer will sell (go

short) on 134 S&P futures contract.
 Step 3: Managing Dealer Risks
∙ Several times a day, the risk managers will
calculate the size of the hedge and the
number of future contracts to employ and
increase/decrease the futures contract
accordingly.
 Step 3: Managing Dealer Risks
∙ In case of a bond, we hedge interest rate
risk.

∙ The standardized measures to deal with the

interest rate risk are
a. Immunization (duration), and
b. dollar value of a basis point (DV01).
DV01 is most commonly used.
 Step 3: Managing Dealer Risks
∙ Dollar value of a basis point is defined as the
dollar amount by which the market value of $
100 of par bonds will change when bond’s
yield changes by one basis point (0.01%).
 Step 3: Managing Dealer Risks
• Whilst dealing interest rate risk of bonds, two steps need to be taken.

• 1) Determine total interest rate risk

• 2) Determine futures contract risk

• 3) Determine number of futures

 Example
∙ A dealer has position in bond portfolio
worth $ 20 million. DV01 is $2. Treasury
bond futures will be used as hedging
instrument and these futures have par value
of $100,000.

∙ How many number of futures will be

required to hedge the risk?
 Answer
• Step1
Total interest rate risk = (size * DV01)/100
= (20,000,000 *2)/100
= 400000
Step 2:
total futures contract risk = (DV 01 * 100,000) / 100
= (2*100000)/100
= 2000
Step 3:
Number of futures = total interest rate risk / futures contract risk
= 400000/ 2000
= 200
 Financing Dealer Inventory

A dealer has to hold inventory positions to serve

its clients (mostly financial institutions).

∙ To finance this, it has to borrow on large scale.

∙ Most financing of dealer positions takes place
in the repo market (repurchase and resale
markets).
 Financing Dealer Inventory
∙ Repurchase agreements are the sale of
securities with an agreement to buy them
back in short time.
 Financing Dealer Inventory
∙ The time can be as short as one day (called
overnight repo), but it can be for few weeks
as well.
∙ The repo market can also be used to obtain
securities for short sale. This transaction is
called a resale (reverse repurchase
agreement).
 Other Dealer Markets
Investment banks also make market for other
securities including:
∙ Repo and resale market;
∙ Swap market;
∙ Mortgaged backed market;
∙ Junk bond market;
∙ Tax-exempt market.
 Brokerage Activity in the
Financial Markets
∙ Broking;
∙ Monitor margin accounts;
∙ Offer investment management services
(e.g., collect dividend and interest, cash
management service);
∙ Assist in structuring portfolios; and
∙ Provide research and recommendations.
 The First Rule of Brokerage:
Know Your Customer
∙ The law requires brokers to act in the best
interest of their customers. Thus it has to know
about its customers.
∙ Client’s name, wealth, and types and duration
of experience in investment.
∙ For example, it will not be prudent to
encourage an elderly person to invest in risky
securities.
 Possible Abuses by Brokers
1. Bucket Shops: Bucket shops are securities
firms (usually small) that take orders from
customers, but do not execute them immediately.
Instead they wait to see whether the price moves
away from the price stipulated in the customer’s
order.
 Possible Abuses by Brokers

2. Boiler Rooms: Boiler room operations are

firms that use high-pressure sales tactics to
sell securities, often to naïve investors.
∙ The boiler room sales personnel get high
percentage of commission (even by 50% or
more) by underwriting worthless or bad
issues.
 Possible Abuses by Brokers
3. Churning: It refers to excessive trading of
a customer’s account to earn commissions
or bid-ask spreads.
- When broker has got discretionary trading
authority
- Or when the client routinely takes advice
from the broker.
 Possible Abuses by Brokers
4. Suitability: The broker may trade
unsuitable securities for its clients. For
example, option trading is unsuitable for an
elderly person.
 Possible Abuses by Brokers
5. Front running: Front running (trading
ahead of a customer) refers to transactions
made by a securities firm for its own trading
accounts in anticipation of trades that are to
be made by a client.
 Possible Abuses by Brokers
6. Poor fills: A broker is entrusted by his
customer to fill an order at best possible
price. This obligation passes from the
account representative to the floor broker.
Sometimes, floor brokers, working in
concert with the floor trader, trade for
customers at disadvantageous prices.
 Possible Abuses by Brokers
7. Circular Trading
A fraudulent trading scheme where sell
orders are entered by a broker who knows
that offsetting buy orders, the same number
of shares at the same time and at the same
price, either have been or will be entered.
This boosts up the volume of the share and
lures in other, unassuming investors.
 Possible Abuses by Brokers / Agents

8. Pump And Dump

A scheme that attempts to boost the price of a stock
through recommendations based on false,
misleading or greatly exaggerated statements.
- The perpetrators of this scheme, who already
have an established position in the company's
stock, sell their positions after the hype has led to
a higher share price.
 Possible Abuses by
Brokers/Agents
9. Poop And Scoop
A highly illegal practice occurring mainly on
the Internet. A small group of informed
people attempt to push down a stock by
spreading false information and rumors. If
they are successful, they can purchase the
stock at bargain prices.
 Possible Abuses by
Brokers/Agents
10. Short And Distort
An illegal practice employed by unethical
internet investors who short-sell a stock and
then spread unsubstantiated rumors and
other kinds of unverified bad news in an
attempt to drive down the equity's price and
realized a profit.