This article will provide a comprehensive explanation of what the ‘price discovery’ process is. It will illustrate its differences from ‘valuation’ and will also explain the procedure’s sensitive factors.
What is it?
‘Price discovery’ is a price determination process that has the alternative name of ‘price discovery mechanism’. It establishes the spot price (or the proper price) of an asset, commodity, currency, and security.
The price discovery procedure looks closely at a number of tangible and intangible factors. These include supply and demand, the attitudes of investor risk, and the general environment in economics and geopolitics. In other words, it is where a buyer and a seller settle on a price and a transaction takes place.
Those with better information and judgment take part in these markets in order to benefit from such information. Let’s assume for instance that good information about the economy arrives. In this case, the spectators’ actions feed their information into the derivatives market. This effectively causes changes in derivative prices.
These markets are typically the first ones to garner a reaction from. This is largely because the transaction cost is comparatively much lower in these markets than the spot market. So, these markets signify what will probably happen and thus, they facilitate superior price discovery.
Price discovery involves pinpointing exactly where supply and demand meet. Economics-wise, there is an intersection of the supply curve and the demand curve at a single price. This allows a transaction to happen. The basic shape of those curves is subject to an array of factors. These range from the size of the transaction to background conditions of prior or future deficiency or abundance. Other key players are location, storage, transaction costs, and buyer/seller psychology.
There is no definite formula that uses all of these factors as variables. The formula is an active and lively process that is susceptible to frequent changes, if not from trade to trade.
In the real world, past, and present
Admittedly, the term itself is a relatively new one. It is a concept and process that is only recently gaining traction and attention. In spite of that, price discovery, as a process, has actually been around for a long time; over a millennium, really.
Examples of recognizable establishments include ancient souqs in the Middle East and marketplaces in a variety of locations. These include Europe, the Indian subcontinent, and China. Altogether, they bring in large groups of traders and buyers to determine goods’ prices. In the modern era, derivatives traders in the Chicago Mercantile Exchange (CME) utilize hand signals and verbal cues to figure out a specific commodity’s price.
Electronic trading serves as a replacement for a majority of the manual processes with mixed results. On the one hand, it results in significant increases in both trading volumes and liquidity. On the other hand, electronic trading leads to excessive volatility and less transparency regarding large positions.
Price discovery vs valuation: what’s the difference?
‘Valuation’ is the analytical process that determines the ongoing worth of an asset or a company. While this and price discovery both appear to be very similar concepts, they are actually not the same thing. Price discovery is a market-driven mechanism, whereas valuation is a mechanism that is model-driven. Valuation is the present value of an array of factors. These include expected cash flows, interest rates, competitive analysis, technological modifications (both in place and in preparation), and many others.
Alternate names for the valuation of an asset are ‘fair value’ and ‘intrinsic value’. When analysts compare market value to valuation, some are able to determine if an asset is overpriced or underpriced. Obviously, the market price is the actual correct price. However, any differences may offer trading opportunities if – and when – the market price adjusts. That is to say, adjust to include any information in the valuation models that were previously not in consideration.
As a process
Instead of seeing price discovery as being a specific process, it should be seen as the central function of any kind of marketplace. This is regardless of whether it is a large financial exchange or something as basic as the farmer’s market.
The market itself ropes in potential buyers and sellers together. There are members of each side that have different reasons for trading along with very different styles for doing so. When buyers and sellers are able to unite, these marketplaces allow interaction between all parties. As a result, there is an establishment of a consensus price. Unbeknownst to all the players, they do it again to appoint the next price, and so on and so forth.
There are an array of factors that price discovery reacts sensitively to. For a specific execution venue, the inputs that could operate the price discovery mechanism include the following:
- The number of buyers
- The number of sellers
- Number of items for sale in that trading period
- Number of recent sales or purchase price (this is the price at which items traded)
- Current bid price
- Current offer price
- Funding availability
- Participant obligations (ex. regulation, exchange rules, Fund Policy)
- Execution costs (market fees and tax)
- Cost, Availability, and Transparency of pricing information in current and other execution venues.
The general cost of execution pertains to all markets. This also includes a street market trader, who may need to pay in order to have a stall. Alternatively, if they need to invest time in going to a village market. They are not necessarily costs of production, but they are a cost acquired to gain access to the execution venue.
Price discovery, on the whole, is a summation of the total market’s sentiment at a certain point in time. It is a versatile, cumulative outlook on the future. It is the process by which every price in every market is determined. The market price is crucial because it is a significant factor in the pricing at off-market execution venues. Moreover, it is important for direct and indirect products. For instance, the price of oil has direct relevance to the overall cost of produce in cold climates.
Market rules establish the times and the total duration for each trade and settlement. There are some markets that may not have an abundance of participants. This is due to the assets being traded not possessing much appeal. The formal term for this is ‘market interest’, which is when participants express their interest in the underlying asset. These markets are often illiquid; an example being minor currencies.
In illiquid markets, price discovery will sometimes take place at an auction time that was established in advance. Alternatively, it could be whenever a participant wants to trade. In these particular cases, it’s possible that there are no executions taking place for days or months. In such examples, there is no price discovery procedure for long periods of time. So, the last traded price is the one that is employed. This often has significant risk because the market for the illiquid may have been subject to relocation. An additional characteristic of illiquid markets is that the trading cost tends to be higher due to low competition.
Dipping and soaring prices
In a more dynamic market, the price discovery process will frequently happen while items are bought and sold. Sometimes the price will drop below the duration average. There are other times when it will exceed the average. In this particular case, it is a result of the noise deriving from uncertainties. Moreover, temporary changes in supply due to the act of buying and selling; in other words, trading.
A closed market has no price discovery procedures. The last trade price is the only thing that is known. It is not uncommon in some markets to not to utilize the actual last traded price, but instead some type of average mean. This is to avoid price manipulation by way of the execution of outliers either on or at the market close. A notable side effect of this practice is that market close prices are not typically available at market close. Even following the publication of the official market close, later issuance of “corrections” is plausible.