What is Price Discovery?
Price discovery is the process of allotting the market prices of tradeable assets based on the buyers and sellers’ approach towards the asset.
Therefore, price discovery enables to set a market price equilibrium for the asset so that the greatest liquidity for the asst is assured.
In simple language, price discovery is the process of determining the price of a product at which the seller and buyers both agrees to negotiate.
However, it is a dynamic process as the market price of a product change quickly. The determination of the market price solely depends on the demand and supply of the product.
However, the demand and supply of the product are driven by several variable factors such as transaction number and size, background conditions of previous or future scarcity or abundance, location, storage, transaction cost, buyer/seller psychology etc.
Moreover, some auction markets allow the buyer and sellers to compete until the market price is decided.
How does Price Discovery work?
The process of price discovery is dynamic and determined by several factors. One of the easiest ways to determine the spot price in economics is through the demand-supply curve.
In economic, the spot price is determined by the intersection point of the demand v/s supply curve.
However, this curve is influenced by a number of factors that consequently influence price discovery.
What are the factors that Influence Price Discovery?
The process of price discovery of determining a consensus price is majorly influenced by the following factors.
1. Supply and Demand
These are the primary factors that influence price discovery. Moreover, demand and supply also exhibit how crucial price discovery is for trading.
For instance, if the supply is greater than the demand, the market price automatically decreases. On the other hand, if the demand is greater than the supply, the market price rises.
Thus, the availability and scarcity of the demands manipulate the buyers and sellers’ approach towards the price discovery.
The volatility of an asset is somehow related to the demand and supply concept. However, some factors may make the asset volatile.
The volatility generally affects the price discovery as same traders agree on higher prices on some volatile asset. They hope to fetch large profits in the near future.
However, volatility involves a potential risk of incurring a substantial loss.
3. Attitude to Risk
The ability of taking a risk by the buyer seller can influence the level of the agreed price.
For instance, the buyer may agree to pay higher than the intrinsic price predicting a potential rise in price in the coming days. It would imply he is willing to take on the risk of a fall in price.
Under such circumstances, the market price is allotted higher than the original value of the product. Moreover, the product will have a higher demand even if the buyer has to spend extra.
However, it would take a few weeks for the price to fall until the buyer realize the sufficient supply of the product in the market.
The risk involved can be determined through risk to reward ratio. It is essential for both the buyers and sellers to maintain an acceptable level of risk.
4. Information Availability
The information available to the public can influence the market price. A public announcement may lead to the rise in demand for an asset and consequently, the fall of price.
For example, buyers tend to wait for the key market announcement before agreeing to pay a price to the seller.
The outcome of such market announcement may lead to an increase in demand or decrease in supply. Thus, the price of the asset may fluctuate in line with the changes mentioned in the market announcement.
5. Market Mechanism
Price discovery depends on microeconomic factors. Therefore, the market mechanism plays a significant role in determining the fairness of the price of an asset.
With price discovery, the investors gain confidence in the quoted price to be fair even if it is higher than the intrinsic value.
In such a situation, the uncertainty surrounding an asset’s price reduces. Consequently, liquidity increases. This may sometimes lead to a reduction in cost as well.
What is the Difference Between Valuation and Price Discovery?
Valuation determines the intrinsic price of an asset, while price discovery determines the market price of the asset.
Valuation involves an analytical process to determines the present worth of an asset. On the other hand, price discovery involves the interaction of buyers and sellers to settle on an agreeable price.
Valuation is driven by a model mechanism whereas price discovery is a market-driven mechanism.
While price discovery depends on the demand and supply, valuation depends on expected cash flow, competitive analysis and technological modifications.
The analysts compare the market price with the intrinsic or fair price to determine whether the asset is overpriced or underpriced. Therefore, the fair price determined by valuation is considered to be the correct price of the asset.
Price Discovery as a process
Price discovery is a central function of any marketplace, be it large financial exchange or a farmer’s marker.
A market is a place where buyers and sellers negotiate on the price of an asset or commodity. Thus, a market itself provides a ground for potential buyers and sellers to unite and interact to establish a consensus price. This process is repeated again for setting the next price and so on.
Even though the term ‘price discovery’ has been coined recently, the process had existed for years. It is indeed an integral part of trading.
Price Discovery and Illiquidity
Market regulations set up the instances and terms of every trade and settlement. Some markets do not have a bounty of participants.
The reason for the limited participant may be the lack of appeal of the property that is being traded. In financial terms, it can be referred to as a lack of ‘market interest’.
This type of markets is often illiquid, i.e., cannot easily be sold or exchanged for cash at a profit. The trader needs to bear a substantial loss of value while selling illiquid goods. One of the popular examples is minor currencies.
Price discovery in illiquid markets is executed through an auction where interested participants are requested to visit at an allotted venue and time.
However, there is a high chance that price discovery of such goods is not executed for months or years. In such a situation, the seller may trade for the last traded price of the goods.
This often has vast threat because the marketplace for the illiquid might also have been difficulty in relocation
Alternatively, an additional risk of illiquid markets is that the trading price has a tendency to be higher due to low competition.
Dynamic Nature of Price Discovery
As the goods or commodities are bought and sold in the market, the process of price discovery is executed frequently. Therefore, this dynamic nature of price discovery leads to dipping and soaring prices.
The spot price may rise above the average duration sometimes while it may dip below the average in some other time. The reason for such fluctuation can be the temporary changes in supply or demand.
Therefore, the Dynamic Nature of Price Discovery is related to its sensitivity to the following factors.
- Size of the market, i.e. the number of buyers and sellers
- Trading duration and quantity
- Last traded price
- Bidding offers
- Participant’s obligations, such as exchange rules and regulations set by SEBI
- Execution costs such as market fees, tax, etc.
- Availability of the trading goods in the market
- Transparency of pricing information in the market.