The price discovery process (also called price discovery mechanism) is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers. The futures and options market serve all important functions of price discovery. The individuals with better information and judgement participate in these markets to take advantage of such information. When some new information arrives, perhaps some good news about the economy, for instance, the actions of speculators quickly feed their information into the derivatives market causing changes in price of derivatives. These markets are usually the first ones to react as the transaction cost is much lower in these markets than in the spot market. Therefore these markets indicate what is likely to happen and thus assist in better price discovery.
- Buyers and seller (number, size, location, and valuation perceptions)
- Market mechanism (bidding and settlement processes, liquidity)
- Available information (amount, timeliness, significance and reliability) including futures and other related markets
- Risk management choices.
"Market" is a broad term that covers buyers, sellers and even sentiment. A single market will have one or more execution venues, which describes where trades are executed. This could be in the street for a street market, or increasingly it could be an electronic or "virtual" venue. Examples of virtual execution venues include NASDAQ, The London Metal Exchange, NYSE, London Stock Exchanges.
After the 2001 Enron scandal, the Sarbanes–Oxley Act tightened accounting rules regarding the "mark to market" method, requiring that only recently discovered prices be used. The intention of this change was to stop companies overvaluing the assets they held. Each night (or reporting period) they would have to take a recently discovered market price obtained from two or more market observers.
Factors of sensitivity
Recent changes in market regulations, post Lehman Bros, have outlined practices that affect the price discovery mechanism. Price discovery is sensitive to many factors. Consider for a specific execution venue the following inputs drive the price discovery mechanism.
- Number of buyers
- Number of sellers
- Number of items for sale in that trading period
- Number of recent sales or purchase price (this is the price as which items traded)
- Current bid price
- Current offer price
- Availability of funding
- Obligations of participants (e.g. regulation, exchange rules, Fund Policy)
- Cost of execution (market fees and tax)
- Cost, Availability and Transparency of pricing information in current and other execution venues.
The cost of execution applies to all markets, even a street market trader may have to pay to have a stall, or invest time walking to a village market. These are not costs of production but a cost incurred to access the execution venue.
Remember that price discovery is a summation of the total market's sentiment at a point in time: a multifaceted, aggregate view on the future. It is how every price in every market is determined. The market price is important as it is a factor in the pricing at off market execution venues and direct and indirect derived products. For example, the price of oil has a direct bearing on the cost of tomatoes in cold climates.
Market rules set the times and duration for trades and settlement. Some markets may not have many participants as the assets being traded do not have much appeal (the formal term is market interest - participants express interest in the underlying asset). Such markets are often called illiquid, for example minor currencies. In illiquid markets, price discovery might take place at a predefined auction time or even whenever participant wants to trade. In such cases there may be no executions for days or months. In such examples there is no price discovery for long periods so the last traded price is used. This can have significant risk as the market for the illiquid may have moved. Another characteristic of illiquid markets is that the cost of trading can be higher due to the lack of competition.
In a dynamic market, the price discovery takes place continuously while items are bought and sold. The price will sometimes fall below the duration average and sometimes exceed the average as a result of the noise due to uncertainties, and transient changes in supply caused by the act of buying and selling: trading. A closed market has no price discovery; the last trade price is all that is known. It is common in some markets not to use the actual last traded price but some sort of average / weighted mean. This is to prevent price manipulation by the execution of outliers on or at market close. One side effect of this practices is that market close prices are not always available at market close, indeed even after the official market close is published, it is possible for "corrections" to be issued later still.
Many derivative contracts are based on "fixings" price snaps are point in time when the market is open. 4 pm is a typical fixing time for some end of day derivative contracts that need access to a price on a specific day where the end of day prices is not used. This is important as is shows the uncertainty that is created when price discovery stops, we are forced to use "official market close" or "last traded" prices which are normally published by the exchanges hosting the execution venues.
Usually, price discovery helps find the exact price for a commodity or a share of a company. Price discovery is used in speculative markets which affect traders, manufacturers, exporters, farmers, oil well owners, refineries, governments, consumers, and speculators.
- Efficient market hypothesis
- Initial Public Offering
- Market-based valuation
- Real estate appraisal
- Stock valuation
- Arbitrage pricing theory (APT)
- Single-index model
- http://agecon.okstate.edu/pricing/ Pricing and Price discovery Issues