Price discovery

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.[1]

Overview

Price discovery is different from valuation. Price discovery process involves buyers and sellers arriving at a transaction price for a specific item at a given time. It involves the following: [2]

"Market" is a broad term that covers buyers, sellers and even sentiment. A single market will have one or more execution venue. The execution venue is where the 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 changing 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.

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. 4pm 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.

See also

References

  1. ↑ Equity Markets in Action: The Fundamentals of Liquidity, Market Structure & Trading, Robert A. Schwartz, Reto Francioni, John Wiley and Sons, 2004
  2. ↑ http://agecon.okstate.edu/pricing/ Pricing and Price discovery Issues
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