After studying this text the learner should / should be able to:
1. Define and explain the meaning of price discovery.
2. Understand the relationship between information and price discovery
3. Describe and illustrate the mechanics of price discovery.
4. Explain the role of the central bank in price discovery.
5. Elucidate the components of interest rates.
6. Explain the connection between price discovery and security valuation.
7. Expound on the role of interest rates in security valuation.
Earlier in this text on the financial system we identified the six essential elements that make up a financial system:
• First: the lenders and borrowers, i.e. the non-financial economic units that undertake the lending and borrowing process.
• Second: the financial intermediaries, which intermediate the lending and borrowing process, meaning that they interpose themselves between the lenders and borrowers.
• Third: the financial instruments (marketable and non-marketable), which are created to satisfy the needs of the various participants.
• Fourth: the creation of money when required, i.e. the unique money creating ability of banks.
• Fifth: the financial markets, i.e. the institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments.
• Sixth: price discovery, i.e. the determination or making of the price of shares and the price of money / debt (the rate of interest).
We have covered the first five, and are now at the last-mentioned. Prices for shares and debt (and deposits) are discovered in the secondary financial markets. We have already discussed various aspects of the secondary market that are pertinent here such as liquidity, spreads, and so on, and will confine ourselves here to the concepts that relate closely to price discovery. The concepts covered are:
• What is price discovery?
• Price discovery and information.
• The mechanics of price discovery.
• Role of the central bank in price discovery.
• The composition of interest rates.
• Price discovery and security valuation.
• Role of interest rates in security valuation.
• Market efficiency.
What is price discovery?
Price discovery is the process / mechanism through which market participants attempt to find what economists call an equilibrium price. It is the price at which the market clears / deals, and can therefore also be called the market-clearing price.
Thus the equilibrium price is the price at which a buyer and seller have agreed to transact a certain quantity of securities. This does not mean that the number of securities have to match exactly, because deals in the financial markets are partially fulfilled at times. For example, a seller of Company A shares may wish to sell 1 000 shares at a price of LCC 100, but the buyer may wish to buy only 500 Company A shares at LCC 100. If there are no other buyers at LCC 100 or if there are buyers at inferior prices, the seller's order will be partially fulfilled. S/he will sell only 500 shares to the buyer.
The financial markets are dynamic markets; therefore the equilibrium price is a moving price. For example, once the deal in the example above is transacted, this new information (price and volume of deal) is an input into the body of information that participants have.
This new information may affect the next market clearing price. The buyer at the next best bid price (say LCC 99), who was about to increase his/her bid price to LCC 100 may decide not to or to make it even lower - on the basis that a selling order was only partially fulfilled. If s/he decides to leave the bid unchanged at LCC 99 the seller may well amend his selling price to LCC 99. In this case a deal will then be struck at LCC 99 and the market clears (fully or partially).
In summary, price discovery is the process of discovering / determining the price of a security in the market place (order-driven or quote-driven market; OTC or exchange) through the bids and offers of buyers and sellers, based on a body of information at their disposal at that time.
In conclusion we need to point out that:
• the equilibrium price is not necessarily the final price paid by the buyer / received by the seller, and
• the equilibrium price often is removed from the Fair Value Price (FVP) of the relevant security.