Price discovery is the process conducted between buyers and sellers, whether explicit or inferred, of setting the spot price or the fair price of any asset that is being traded. It includes evaluating tangible and intangible factors including supply and demand, investor risk attitudes, and the overall economic and geopolitical environment.
Simply put, price discovery is the point at which a buyer and a seller agree on a price and a transaction occurs.
Key Takeaways
- Price discovery is the central function of a marketplace.
- It is the process through which buyers and sellers agree on the current value of a financial asset or commodity.
- Price depends on a variety of tangible and intangible factors, from market structure to liquidity to information flow.
The Law of Supply and Demand
The balance between buyers and sellers is a key factor in price discovery. The law of supply and demand is the main factor driving price.
Understanding Price Discovery
At its core, price discovery involves finding where supply and demand meet.
In economics terms, the supply curve and the demand curve intersect at a single price, which then allows a transaction to occur. The shape of those curves is subject to many factors, from the size of the transaction to background conditions of previous or future scarcity or abundance. Location, storage, transaction costs, and psychology also play a role.
There is no specific formula using all these factors as variables. Indeed, the formula is a dynamic process that can change frequently, if not from trade to trade.
History of Price Discovery
While the term itself is relatively new, price discovery has been around for millennia as a process. Ancient souqs in the Middle East and marketplaces in Europe, the Indian subcontinent, and China brought together traders and buyers to establish acceptable prices of goods.
In modern times, derivatives traders in the pits of the Chicago Mercantile Exchange (CME) used hand signals and verbal cues to signal prices for a given commodity.
Electronic trading has replaced most of the manual processes with mixed results. While it has significantly increased trading volumes and liquidity, electronic trading has also resulted in more volatility and less transparency about large positions.
Price Discovery As a Process
Price discovery is the central function in any marketplace, whether it is a financial exchange or a local farmer’s market. The market brings potential buyers and sellers together, with members of each side having very different reasons for trading and varying styles for doing so.
By bringing buyers and sellers together, marketplaces allow the interested parties to interact, and by doing so a consensus price is established. Whether they’re consciously aware of it or not, all the players do it again to set the very next price, and so on.
Price discovery is influenced by a wide variety of factors. Among these factors are the stage of market development, its structure, security type, and information available in the market.
Those parties with the freshest or highest quality information have an advantage as they can act before others get that information. When new information arrives, it changes both the current and future condition of the market for that asset and therefore can change the price at which both sides are willing to trade.
Too much transparency in information can be detrimental to a market because it increases the risks for traders moving large or significant positions.
Price Discovery vs. Valuation
Price discovery is not the same as valuation. Price discovery is a market-driven interactive process, while valuation is a model-driven mechanism. Valuation is the present value of presumed cash flows of an asset, based on many factors including interest rates, competitive analysis, and technological changes both in place and envisioned.
Other names for valuation of an asset are fair value and intrinsic value. By comparing market value to valuation, analysts can conclude whether an asset is overpriced or underpriced by the market.
The market price is considered the correct price, but any differences can provide trading opportunities if and when the market price adjusts to include any information in the valuation models not previously considered.
Is Price Discovery a Transparent Process?
Price discovery has to be transparent in order to work correctly for both buyers and sellers. Consider the traditional auction process. If a bidder did not know what prices were being offered by other buyers, it would be impossible to establish a fair price for any participant.
Which Comes First: Price Discovery or Valuation?
Valuation comes first. A buyer or seller determines an acceptable price, or price range, for an asset based on many factors. In fundamental stock analysis, for example, this includes looking at a company’s earnings history, its competition, its management, and the product plans it has in the pipeline. That gives the buyer a way to project a stock’s potential growth and set a fair price or price range for it. The buyer only then is ready to enter the interactive process of price discovery.
How Do I Use Price Discovery When I Use an Online Broker?
Whether you’re aware of it or not, you’re using price discovery every time you buy or sell a stock or other asset. The current quote is either acceptable or unacceptable to you as a buyer or seller. If it’s unacceptable, you wait until it changes.
The Bottom Line
Price discovery is an integral part of the process of buying and selling in a stock market, or in any marketplace. It’s the point at which a buyer and a seller agree on a price that is acceptable to both parties.
Related Terms: spot price, valuation, market price, supply curve, demand curve.
