What Is a Markup?
Let me explain to you what a markup is. It's the difference between an investment's lowest current offering price among broker-dealers and the price charged to the customer for that investment. This happens when brokers act as principals, buying and selling securities from their own accounts at their own risk, rather than just getting a fee for facilitating a transaction. Most dealers are brokers, and vice versa, which is why the term broker-dealer is so common.
You see markups in retail settings too, where retailers increase the selling price of merchandise by a certain amount or percentage to earn a profit. There's a pricing method called variable cost-plus pricing, where a retailer sets a selling price by adding a markup to total variable costs.
Key Takeaways
- A markup is the difference between the market price of a security held by a broker-dealer and the price paid by a customer.
- Markups are a legitimate way for broker-dealers to make a profit on the sale of securities.
- Dealers are not always required to disclose the markup to customers.
- In retail settings, markups occur when retailers increase the selling price of merchandise by a certain amount or percentage to earn a profit.
Understanding Markups
Markups come into play when marketable securities are available for purchase by retail investors from dealers who sell them directly from their own accounts. The dealer's only compensation is the markup, which is the difference between the security's purchase price and what the dealer charges the retail investor. The dealer takes on some risk because the market price could drop before the security is sold to investors.
In business, the markup is the price spread between the cost to produce a good or service and its selling price. To ensure a profit and recover production costs, producers add a markup to their total costs. They express this markup as either a fixed amount or a percentage over the cost.
Markups vs. Markdowns
A markdown, on the other hand, happens when a broker buys a security from a customer at a price lower than its market value. Markdowns also occur when a dealer charges a customer less for a security than the current bid price among dealers. Dealers might do this to encourage more buying, offsetting initial losses with extra commissions.
For retailers, a price markdown is a deliberate cut in the selling price of a good. Retailers might markdown goods for several reasons. For seasonal items, they could be clearing shelves for next season's stock, even if it means taking a loss. Manufacturers might release new models yearly or every few years, leading to markdowns on older products to avoid obsolete inventory.
Benefits of Markups
Markups provide a legitimate way for broker-dealers to profit from selling securities. Securities like bonds are traded with a spread, determined by the bid price—what someone is willing to pay—and the ask price—what someone is willing to accept.
When a dealer acts as principal, they can mark up the bid price, widening the bid-ask spread. The difference between the market spread and the dealer's marked-up spread becomes their profit.
Important note: Instead of charging a flat fee, brokers acting as principals can get compensated through the markup, which is the gross profit from securities they hold and later sell to customers.
Special Considerations for Markups
The dealer only has to disclose the transaction fee, which is usually a small cost. This means the buyer doesn't know about the dealer's original transaction or the markup. From your perspective as a buyer, the only cost for the bond purchase seems to be that small fee. If you try to sell the bonds right away on the open market, you'd have to cover the dealer's markup on the spread or take a loss. This lack of transparency means you, the bond buyer, have to figure out if you're getting a fair deal.
Dealers compete by reducing their markups. You can compare the price the dealer paid for the bond with what you're charged. Bond transaction details are available through sources like Investinginbonds.com, which reports daily on all bond transactions.
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