Question

(Related to the Chapter Opener on page 252) Were the shares of stock issued as a result of Snap's initial public offering (IPO) sold in a primary market or a secondary market? Was the IPO an example of direct finance or indirect finance?

Short answer

Snap's IPO was an instance of direct finance in the primary market.

Step-by-step solution

Understanding Primary and Secondary Market

Primary markets are where the stock debuts for the first time and investors can buy it directly from the company. The shares of Snap during its IPO were issued for the first time. Therefore, the issuance took place in a primary market.

Understanding Direct and Indirect Finance

In case of an IPO, the company puts up its shares on the stock market to raise money from the public directly, without any intermediaries or banks. Hence, it is an example of direct finance.

Key concepts

Primary Market

The primary market plays a key role when a company decides to raise funds by issuing securities for the first time, which is known as an Initial Public Offering (IPO). This market is characterized by direct transactions between the company and investors. In the context of Snap's IPO, the company offered its shares to the public for the very first time. Here, investors had the unique opportunity to purchase shares directly from Snap, which can be seen as the birthplace of these securities.

It's essential to understand that the primary market doesn't provide the opportunity for buying and selling of pre-owned shares. Instead, it facilitates the original sale of securities, making it distinct from the secondary market where securities are traded after their initial issuance. The IPO process is also influential in setting the initial price of the securities, typically through an underwriting process where investment banks might be involved in helping determine the offering price and selling the initial shares to investors.

Secondary Market

Once securities are issued in the primary market, they make their way to the secondary market, where subsequent trading occurs. This is where investors buy and sell securities from each other, without the issuing companies directly participating in the transactions. The secondary market includes stock exchanges like the New York Stock Exchange or NASDAQ, as well as over-the-counter (OTC) markets.

One crucial aspect of the secondary market is liquidity, enabling investors to easily convert their securities into cash. This market is also where the price of securities fluctuates based on supply and demand dynamics. After Snap's IPO, investors who purchased shares in the primary market could choose to sell them in the secondary market, potentially profiting from price changes.

Direct Finance

Direct finance occurs when borrowers directly obtain funds from lenders in the financial market without intermediaries like banks, brokers, or financial institutions. When a company such as Snap conducts an IPO, it engages in direct financing by issuing new shares to the public. Investors who buy these shares are directly providing the company with the capital it needs to expand its operations, develop new products, or invest in growth opportunities.

Direct finance is advantageous because it allows companies to bypass traditional banking channels, which might involve additional fees or stricter lending standards. In Snap’s case, the IPO enabled them to receive funds directly from the wide array of public investors who purchased the shares, making it a clear-cut example of direct finance.

Indirect Finance

In contrast to direct finance, indirect finance involves financial intermediaries like banks, credit unions, or investment funds that act as a buffer between savers and borrowers. These intermediaries collect funds from savers and lend them out or invest them on behalf of these savers. The process usually includes deposit accounts, loans, and investment pools, where the intermediary makes its profit through interest spreads and service fees.

In the sphere of indirect finance, borrowers don't interact with the actual lenders. Instead, they obtain resources from the intermediary, which takes care of amassing and managing the funds. While Snap's IPO can be classified as an example of direct finance, indirect finance plays a significant role in the broader financial system by providing individuals with a way to save and invest without the need to directly engage in the financial markets.