Type and Functioning of Markets
This domain tests how securities are issued and traded: primary versus secondary markets, exchange versus over-the-counter trading, order-driven versus quote-driven mechanisms, and the mechanics of orders, clearing, and settlement. Expect questions that compare market structures or calculate an execution price.
Market types
In the primary market, an issuer sells new securities to investors and receives the proceeds. In the secondary market, investors trade existing securities among themselves; the issuer receives nothing. Money markets trade short-term debt of one year or less; capital markets trade longer-term debt and equity.
Trading mechanisms
- Quote-driven (dealer) markets: dealers post bid and ask prices; investors trade at the dealer's price, and the spread compensates for risk and inventory.
- Order-driven markets: buyers and sellers submit limit orders to a central book; a matching engine applies price priority, then time priority.
- Continuous versus call markets: continuous trading executes as orders arrive; call auctions batch orders at a single price.
- Exchange-traded versus OTC: exchanges offer standardized, cleared products and transparency; OTC is bilateral, customized, and carries counterparty risk.
Key mechanics
A market order demands immediate execution at the best available price. A limit order sets a maximum buy price or minimum sell price. Liquidity is the ability to trade quickly at low cost without moving price. Short selling borrows securities to sell now and buy back later, profiting if price falls; it requires margin and creates recall risk. Clearing matches trades; settlement transfers cash and securities.
Worked example
An order book shows bids of 500 shares at 49.90 and 300 at 49.85; asks of 200 at 50.00 and 400 at 50.05. A market buy for 500 shares executes 200 at 50.00 and 300 at 50.05. Average price = (200 x 50.00 + 300 x 50.05) / 500 = (10,000 + 15,015) / 500 = 50.03. The buyer pays 3 cents per share above the best ask because the order consumed liquidity, a real cost of a large market order.
Traps
- Saying the issuer raises money in the secondary market.
- Treating a limit order as guaranteed to execute.
- Ignoring that OTC trades still settle and carry counterparty risk.
- Confusing the money market with the foreign exchange market.
- Forgetting that price priority comes before time priority on most order books.