EI 3 Equity Issuance and Trading

Public equity markets do two jobs at once. They give growing and established companies a source of new ownership capital, and they give investors a venue for buying and selling shares that already exist. That split defines the two halves of the market. In a primary equity market an issuer brings a new equity security to market and sells it to raise ownership capital, or turns an existing private stake into publicly held equity. In a secondary equity market, shares that were issued earlier change hands between investors. Beyond liquidity, secondary markets deliver price discovery for investors and continuous performance feedback to management and other stakeholders.

Routes into the public market

A firm most commonly moves from private to public ownership through an initial public offering (IPO), in which a company held privately makes its debut on the public equity market. These firms normally retain investment banks to underwrite the placement of new shares. Shares may be placed through a public offering open to all investors or through a private placement limited to a selected investor or group of investors. Less common routes are a special purpose acquisition company and a direct listing. A direct listing puts shares that already exist onto an exchange at a market-set price, without any underwriter.

Primary issuance usually reflects a transfer from private to public hands, and it can arise in several ways: an early-stage firm expanding beyond founder and venture capital financing; a new public company formed when an existing public company carves out or spins off a division; or a formerly listed firm returning to the market after private owners have restructured it over several years. A national or regional government may also use the primary market for a full or partial privatization, selling part or all of a state-held corporation to public investors. The July 2023 listing of Hidroelectrica, a Romanian hydropower company, raised over 9 billion Romanian leu (RON) while the government retained roughly 80 percent; the sale came through a Bucharest Stock Exchange listing of a minority stake, and Hidroelectrica became the largest Romanian company on the exchange.

The IPO process

Whatever the issuer’s size or target investors, primary issuance means satisfying listing and regulatory requirements and then soliciting investors for the new shares. Two work streams run in parallel: documentation and marketing.

The prospectus, or offering memorandum, is the key document. It describes the company and its business model, the main industry and business risks, audited financial statements, and details such as how many shares will be issued, the likely price range, the schedule, and where the proceeds will go. During marketing, management and advisers introduce the company to analysts and investors, gauge acceptance, and settle on a price range. Unlike fixed-income book building, which often happens on the issuance day itself, equity issuers spend much longer educating investors about the business before the offer price is set.

Why IPOs tend to be underpriced

Underwriters face pricing incentives that conflict with those of the owners. A higher offer price raises fees, but underwriters often gain more by placing underpriced shares with preferred institutional clients. Those clients keep coming back for allocations because the discount tends to produce attractive early returns, so underwriters have little reason to push for the highest possible price. The usual result is a jump in the share price on the first trading day. Studies by Jay Ritter, covering more than 9,000 US IPOs from 1980 to 2023, put average first-day underpricing at roughly 20 percent, equivalent to about USD233 billion of proceeds that issuers could hypothetically have captured at the first day’s closing price. Underpricing is not uniform: US IPOs in 2020 were underpriced by more than 40 percent on average, yet almost 22 percent of that year’s issuers had negative first-day returns, meaning they were overpriced.

Why do issuers accept less? Ritter suggests managers treat the first-day pop as a visible gain on the shares they already hold, and value that more than the proceeds forgone, which are only an opportunity cost to the firm. This is a version of the principal and agent problem, with shareholders as principals and managers as agents.

Seasoned offerings: dilutive or not

A seasoned equity offering, also called a follow-on offering, sells additional units of a security that has already been issued. It still needs a prospectus, but the process is usually faster because the market already knows the issuer. Such an offering may be dilutive or non-dilutive. A dilutive follow-on (a primary follow-on) sells newly created shares, which reduces each existing share’s proportional claim on the firm’s net income and assets; firms use it to raise capital for investment or to cut debt. A non-dilutive follow-on (a secondary follow-on) sells existing privately held shares into the public market for the first time, leaving each shareholder’s proportional claim unchanged and letting founders and early investors diversify concentrated positions.

What secondary markets provide

Being able to trade shares is only the start. Secondary markets deliver price discovery along with further benefits for investors, issuers, and stakeholders. Observed prices let investors measure periodic returns and give analysts a reference point when they estimate value with equity valuation techniques. Issuers and stakeholders read market prices as a gauge of company performance, and access to current and historical prices lets investors compute returns, volatilities, and correlations and build portfolios with an efficient risk-return tradeoff. Secondary prices also feed corporate decisions: a firm whose price is climbing may pursue a follow-on offering, while one whose price is depressed may favor share repurchases over dividends. Firms that pay directors and staff with restricted stock units (RSUs), shares that cannot be sold during a multi-year vesting period, likewise track secondary prices to gauge the value of that compensation.

Secondary markets keep functioning in both rising and falling conditions, unlike primary issuance, which is most active when prices are climbing. In 2020, the S&P 500 Index rose 18.4 percent for the year, yet it lost over a third of its value between late February and late March amid the COVID-19 shock, on above-average trading volume, before fiscal and monetary support drove it more than two-thirds higher from the March low. Gains were uneven across sectors: Information Technology and Consumer Discretionary led with returns above 47 percent and 34 percent, while Energy and Passenger Airlines each fell by roughly a third. Throughout, investors could still buy and sell, which is exactly the resilience secondary markets are meant to offer.

Once shares exist, where they trade shapes how easily they can be bought and sold. Three broad venues matter: an order-driven exchange, off-exchange execution through a broker-dealer, and a quote-driven over-the-counter market.

Exchange trading

An equity exchange is a venue governed by rules where participants trade shares on a regular basis. Its rules aim to promote liquidity and transparency: fixed trading hours each business day and an order matching system that links buy and sell orders. Trading runs through firms that are exchange members registered as broker-dealers. These intermediaries either act as agent on behalf of clients or serve as principal counterparty to a trade. For exchange-traded equities the broker-dealer usually acts as agent, routing client orders into the exchange system. Orders are typically entered in standardized lots of at least 100 shares. Exchanges frequently appoint one dealer, the market maker, to keep each listed security trading smoothly and continuously by buying, selling, or holding shares, especially at the open and close and during imbalances or high volatility.

These rules and central systems seek a liquid market, which is judged partly by the explicit costs of trading, the out-of-pocket fees and commissions, and partly by an implicit cost, the bid-ask spread (also called the bid-offer spread).

The ask (or offer) is the price a trader is willing to accept to sell a stated quantity, while the bid is what a trader will pay to buy a stated quantity. The spread may be shown in absolute currency, as above, or scaled by the lowest ask price into a percentage.

Exchange rules also support different order types. A market order tells the broker to buy or sell a set number of shares at the best price currently available. A limit order adds a price constraint: a buy limit order caps the price paid, and a sell limit order sets a minimum price to receive, so the order goes unfilled if the price is not reached. The limit order book collects these resting orders. Its shape reveals market depth, the size of orders sitting at or very near the best bid and offer, and roughly balances buy limit orders below the current price against sell limit orders above it. The midpoint between the two best prices is the mid-market price, often used to estimate execution cost.

Traders also follow a running measure across the day, the volume-weighted average price (VWAP), which weights each traded price by the volume at that price over a period.

To trade on an exchange, a stock must be listed and keep meeting listing requirements, which typically cover a minimum number of shareholders, minimum holdings per shareholder, minimum book equity or net worth and profitability, and a minimum percentage of stock held publicly. Some exchanges cater to smaller, earlier-stage firms. Canada’s TMX Group runs two: the Toronto Stock Exchange (TSX) for larger, mature issuers, and the TSX Venture Exchange (TSXV) for early-stage and smaller firms, many not yet profitable and concentrated in sectors such as mineral exploration and technology. In 2022 the quoted market value of TSX companies was CAD3,792 billion against CAD70 billion for TSXV, though each exchange listed over 1,700 companies; average capital raised was CAD50 million on TSX versus CAD4.4 million on TSXV, and 16 issuers graduated from TSXV to TSX that year.

Off-exchange trading

Small to moderate trades are absorbed easily by the exchange, but some trades execute better directly with a broker-dealer. These usually involve illiquid shares, very low-volume trades in low-priced shares from retail investors, or very large orders known as block trades. A block trade is usually taken to mean an order of at least 10,000 shares in one issuer. Blocks are often sent to a broker-dealer that breaks them into smaller orders worked over time, or sends smaller pieces to several parties at once, to limit the adverse price impact. Asset managers such as mutual funds may instead agree to exchange shares bilaterally or multilaterally at a closing price, away from the exchange order system.

Off-exchange trading mainly seeks to reduce the implicit costs of trading, the indirect and largely unobservable costs from the market impact of trading. Apart from the bid-ask spread, implicit costs come from three sources:

• Market impact (or price impact): the cost that immediate execution imposes on transaction prices, since filling a large order often means moving the price to attract counterparties.
• Delay costs (slippage): the loss from being unable to complete a trade at once, so the order fills only after prices have moved as expected.
• Opportunity costs: the forgone profit when an order is not executed at all and prices then move as expected.

Over-the-counter trading

Over-the-counter (OTC) trading relies on a web of broker-dealers who trade shares among themselves instead of through a central system. It is a quote-driven market, and it typically hosts smaller firms that either avoid the cost of listing on a larger exchange or fail to meet its requirements. Instead of one designated market maker on a central platform, a quote-driven system has multiple market makers, usually broker-dealers, continuously showing bid and ask prices. They fill an order from their own inventory or match it against another market maker or investor. Since a market maker is bound to trade at its quoted prices, a quote-driven system usually gives the best chance of execution across most conditions. The tradeoff is less transparency than an exchange, since individual orders are not readily visible; buyers and sellers have no assurance of the best available price, and OTC dealers may pull back on liquidity during market stress.

Equity liquidity is how readily shares can be bought or sold, judged on both price and speed. The explicit and implicit trading costs covered earlier swing widely with order size, order timing, and fresh information. A useful quantitative view of turnover connects two quantities: market float and average daily volume. Market float here means the number of issuer shares available to trade freely in the public market, not the total market value of those shares.

Average daily volume is the average number of shares traded per business day over a chosen period of n days.

Dividing average daily volume by market float gives the turnover ratio, an indication of the proportion of tradable shares that changes hands on a given day. This comparison matters most for large positions in smaller companies, where the ability to exit can be constrained by thin trading.

Depth, breadth, and resiliency

Liquidity extends beyond transaction costs and the daily turnover proportion to three further features. Market depth is the size of orders resting at or very near the best bid and offer. Market breadth is the number of orders at various price levels just above and below the best bid and offer. Together, depth and breadth capture the number, size, and dispersion of orders in the book. Ample depth and breadth let managers execute reasonably sized trades quickly without moving the price much, which is exactly what algorithms rely on when they split a large order into smaller parts for smooth execution.

Market resiliency is the ability of a stock to hold a stable market-clearing price, the price at which all buy and sell orders can be filled with no excess demand or supply, and to return to such a price quickly after a shock. A shock produces an initial price change, softened by greater depth and breadth, followed by settling toward a fresh market-clearing price. How fast that adjustment happens turns not only on visible orders but also on hidden ones: orders brokers do not reveal, orders with special conditions, blocks executed in pieces, and computer-triggered trades. These unobservable forces can drive significant intraday volatility.

Equity indexes let market participants track risk and return, evaluate performance, benchmark managers, and build indexed investment strategies. An index normally contains a set number of constituents, each standing for one issuer’s common shares. Each issuer’s share price feeds the index value according to a weighting method, most often based on market capitalization, on price, or on other fundamental factors.

A worked example of a broad-based index

The NIFTY 50, launched in 1997, tracks 50 of the biggest firms listed on India’s National Stock Exchange (NSE). It applies a float-adjusted market capitalization weighting, and its value states the combined market value of its stocks against a 1995 base value of 1,000. By 2024 its heaviest member was HDFC Bank at over 13 percent weight, whereas the lightest, the chemical company UPL, sat below 1 percent. Financial services made up over 30 percent of the index value, followed by information technology at 14 percent and oil and gas at 11 percent. Constituents are reviewed semi-annually, with extra changes on delistings, mergers, or other corporate actions. Covering roughly two-thirds of NSE market value and a little over half of its trading volume, the NIFTY 50 gives a broad read on the Indian market and sits beneath the most heavily traded equity derivative contract in the world.

Broad-based and composite indexes

Most broad-based indexes for a market include the largest listed firms, adjust for market float, and weight by market capitalization. The most comprehensive version is a composite index, which usually includes securities representing more than 90 percent of the market’s value. Composites are commonly split by size to separate large-, mid-, and small-cap performance. The NIFTY 500 composite, for instance, feeds three size-based indexes.

Sector, theme, and alternative-weight indexes

Size-based indexes have a limitation: a broad capitalization-weighted index is dominated by its largest firms and most concentrated industries. Sector indexes address this by grouping firms in the same business, which supports competitor benchmarking and industry-specific investment products. Theme-based indexes go further, grouping firms by an investment trend rather than by industry or size. NSE examples include firms focused on domestic Indian sales (NIFTY India Consumption), capital-intensive essential-service assets (NIFTY Infrastructure), issuers screened for compliance with Islamic law (NIFTY 50 Shariah), and issuers screened for environmental, social, and governance principles (NIFTY 100 ESG).

Alternative weighting methods have gained ground against perceived biases in standard market-cap weighting. The simplest is an equal-weighted index built on the same constituents as a cap-weighted one: in the NIFTY 50 Equal Weight index, the biggest member (HDFC Bank) and the smallest (UPL) each carry a weight of 2 percent, removing the extra emphasis a cap-weighted method gives to the biggest and most appreciated firms. Fundamental-factor indexes weight by measures other than market capitalization, such as revenue, earnings, dividends, or book value. The MSCI Quality Indexes illustrate the approach: MSCI computes a quality score from three standardized financial ratios, profitability gauged by return on equity, earnings stability gauged by earnings variability, and balance sheet strength gauged by the debt-to-equity ratio, then tilts each stock’s cap weight by that score. Firms scoring below zero are dropped, and high scorers are overweighted; overall the quality indexes hold about 20 percent of the parent index’s stocks and roughly 30 percent of its market capitalization.

Multi-market indexes

Multi-market indexes combine indexes from different groups of countries to represent several security markets at once, spanning multiple nations, regions, levels of development, or the whole world. Products built on them let investors offset a home asset bias using an instrument traded on a domestic exchange; returns then include foreign index performance plus currency gains and losses, even when the product is denominated in the investor’s home currency. The MSCI Emerging Markets Index holds large- and mid-cap issuers drawn from 24 developing markets spanning Asia, Europe, Africa, South America, and the Middle East; its 1,400-plus constituents cover about 85 percent of the free float-adjusted market value within each market. Asset managers use such an index to benchmark pooled funds of similar risk and return: BlackRock’s institutional Emerging Markets Fund (MADCX) benchmarks against it and invests at least 80 percent of assets in developing capital markets.