Where you are. Every instrument you have priced so far already existed: somebody held it, somebody wanted it, and the market’s job was to agree a price between them. This lesson steps back one move. Before a bond can trade, it has to be sold for the first time by the borrower who created it, and that first sale is a different mechanism with different rules.
Selling a thousand of something that has never had a price
A government needs to borrow. It will issue a thousand units of new five-year debt, and it needs to know what to charge.
It cannot look up the price, because this bond has never traded. It can look at similar bonds, which gets it close, but similar is not the same and the amount is large enough that guessing wrong is expensive: price it too high and the sale fails in public, too low and it has given money away.
So it does not set a price at all. It asks everyone what they will pay, and lets the answers determine the price.
The idea in one paragraph
The primary market is where securities are created and sold for the first time, and it exists to solve a problem the secondary market never faces: setting a price for something that has none. Government debt is usually sold by auction, where bidders state what they will pay and how much they want, the best bids are filled until the issue is exhausted, and - in the common uniform-price design - everybody who fills pays the same price, the one at which the last unit sold. Equity is usually sold differently, through bookbuilding, where a bank collects indications of interest and the issuer picks a price and an allocation with more discretion. Both mechanisms produce two numbers worth reading afterwards: the price at which the sale cleared, and how much demand there was in total compared with what was on offer.
The auction, filled from the top
Five bidders want the thousand units. They bid different prices for different amounts: a bank treasury at 99.95 for 300, an insurer at 99.90 for 350, a pension fund at 99.80 for 400, a dealer desk at 99.60 for 500, a retail book at 99.50 for 250.
Sort from the best price down and fill. The bank treasury takes 300, the insurer 350, and that is 650 of the thousand. The pension fund’s 400 would take it to 1,050, so it fills 350 of its 400 and the issue is gone. The dealer desk and the retail book get nothing; they bid too low.
Now the part that surprises people. In a uniform-price auction, everybody who filled pays 99.80 - the price of the last unit sold - including the bank treasury that offered 99.95.
Here, 1,800 was bid for 1,000 on offer: a cover of 1.8. The clearing price of 99.80 and that cover ratio are what the market reads the next morning, and a weak auction of government debt is genuinely news, because it says the market is losing appetite for lending to that government at those rates.
The other route
Equity usually does not work this way. An IPO is bookbuilt: a bank spends weeks collecting indications of interest, builds a picture of demand at various prices, and then the issuer and the bank choose both the price and who gets shares.
That discretion is the point and the controversy. It lets the issuer choose long-term holders over quick flippers, and it lets a bank favour its own good clients. When a stock jumps on its first day of trading, the gap between the offer price and the first trade is money the issuing company did not receive, which is why “leaving money on the table” is a phrase every IPO argument reaches for eventually.
Check yourself
1. Why can a new bond’s price not simply be looked up before the auction?
Because the security does not exist yet and has never traded, so there is no price to look up. Comparable bonds narrow the range, but for a large issue the residual uncertainty is expensive: too high and the sale fails publicly, too low and the issuer gives money away. The auction turns that guess into a measurement.
2. The bank treasury bid 99.95 but pays 99.80. Why does the issuer accept less than it was offered?
Because charging each bidder their own bid punishes honest bidding: everyone would shade down toward their guess of the clearing price, and the auction would measure guesses rather than willingness to pay. Uniform pricing keeps the bids honest, which produces better price information and generally better proceeds.
3. A government auction comes in with a cover ratio just above one. Why is that news?
Because it means the issue barely attracted enough demand to sell, so the market’s appetite for lending to that government at that yield is thin. It signals that future issues may need to pay more, which matters for the government’s cost of borrowing and, through the curve, for pricing everything else.
4. A stock jumps 40% on its first trading day. What does that say about the offer price, and who bears the cost?
That the offer price was well below what buyers were willing to pay. The gap is money the issuing company did not raise: it went to whoever was allocated shares at the offer price. Whether it is a mispricing or the price of guaranteeing a successful sale is exactly the argument that surrounds every bookbuilt IPO.
Do this
Run the auction, find the clearing price, and check who fills.
python3 code/auction.pyThe starter leaves you allocate, which sorts the bids from the best price down, fills until the issue is exhausted - the last fill may be partial - and returns both the allocations and the marginal price everyone pays. The assertions check the whole issue sells, that the clearing price is 99.80, that the marginal bidder is filled partially, that nobody below the clearing price fills, and that no filled bidder bid below what they pay. Success prints the ladder and the line:
clearing price 99.80, proceeds 998.00: everyone who filled pays the same price, including the ones who bid moreThe completed version is in solutions/auction.py.
What you can now do. You can run a uniform-price auction, explain why it charges the marginal price, and read a cover ratio. That is how a security is born. The next lesson is about every moment after that, when the security is in the wild and its price is set not by an auction but by a queue.