Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Who typically participates in the third market?

1. Individual investors

2. Institutional investors and broker-dealers

3. Retail investors

4. Only government entities

The correct answer is: Institutional investors and broker-dealers

The third market refers to the trading of exchange-listed securities in the over-the-counter (OTC) market, primarily handled by institutional investors and broker-dealers. This market allows for the buying and selling of securities away from the primary exchange, which can provide greater flexibility and more favorable pricing for larger trades. Institutional investors participate in the third market because they often have significant trading volumes and seek to execute large orders without adversely impacting the market price on the principal exchange. Broker-dealers facilitate these transactions, providing the necessary infrastructure and liquidity. This dynamic is especially beneficial for managing large blocks of shares discreetly, thus avoiding the visibility that comes with trading on an exchange. Other participants like individual investors and retail investors are typically less common in the third market since they usually trade on recognized exchanges or through online platforms designed for retail trading. Only government entities participate under specific circumstances, primarily related to regulatory compliance or strategic investment purposes, which do not represent the primary profile of the third market participants. Hence, the correct choice emphasizes the dominant role of institutional investors and broker-dealers in this market.