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Price discovery and information
Discovered prices are founded on information available to the market participants and the sometimes irrational behaviour of certain participants (the "herd instinct"). While prices are determined by solid information and irrational participant behaviour, at the same time financial instrument prices provide useful information that is used in the making of economic decisions. Examples are:
• The obvious one: prices assist in decisions regarding the allocation of the scarce resource: capital.
• Debt / share prices provide information on the market's perception of the value of these assets (this can be different from the FVP of the securities).
• These secondary market prices assist in the determination / setting of the prices of primary market issues.
• Some economic indicators include share / debt prices (for example the leading economic indicator).
• Derivative instrument prices provide information on the market participants' views on spot prices in the future.
• Long-term interest rates provide information on market participants' views of short-term interest rates in the future.
• The pricing of derivative instruments provides information that assists in decisions on the hedging of naturally long or short positions. Examples are maize farmers (naturally long) and flour millers (naturally short). The removal of risk has major economic benefits.
The mechanics of price discovery
As we have seen, there are two "types" of markets:
• Order-driven markets.
• Quote-driven markets.
Figure 1: bid and offer prices and spread
The below analysis applies to both markets, which are dynamic, i.e. bid and offer prices change constantly in the light of market information, including the last price and quantity / volume traded, the present best bid and offer prices and quantities, and the other "inferior" bid and offer prices and quantities at these prices. "Inferior" refers to the prices that are away from the best prices (in most markets these are visible to participants, making the market transparent).
Bid (buying), offer (selling) prices and spread (difference between bid and offer) are terms usually confined to quote-driven markets and they are therefore the bid and offer prices quoted simultaneously by market makers. However, the best bid and best offer prices may not be from the same market maker, as in order-driven markets. This is good motivation to apply these terms to order-driven markets. There is another, and it is that these markets (like many quote-driven markets) are usually ATS markets where an electronic order book matches orders. When they do not match they are much like the bids and offers of market makers, with the differential simulating the spread.
In Figure 1 we present the traditional demand and supply curves. The equilibrium price (pe) is at the intersection of the demand and supply curves, and this also indicates the volume of the deal, i.e. the quantity Q which was dealt at the pe.
It will be evident that this illustration does not fit well with a dynamic market. The bid price pb is correctly lower than the offer price po, but pb should intersect the demand curve and po should intersect the supply curve (which they don't).Therefore we shoulddeletefhe cravaonfie left of friepi and illustrate this as in Figure 2.
Figure 2: bid and offer prices, spread & mid-price
This is a more sensible illustration. The best bid and offer prices at quantity Q will be at the extreme left of the curves and the inferior bids and offers to the right on the curves. Generally, inferior bids and offers will be at higher quantities, because buyers / sellers will be prepared to deal in larger quantities at inferior prices.
As we saw earlier, the spread is the difference between the best bid and offer prices. The mid-price pm is midway between the best bid and offer prices [pb + (po - pb) / 2)]. The equilibrium price is established when the bid and offer prices coincide at a quantity acceptable to the buyer and seller.
The spread should be seen as the reward for the market maker for risk inherent in quoting bid and offer prices simultaneously (in quote-driven markets), and simply the views of buyers and sellers in order-driven markets.
An example will be useful (see Figure 3). At an (equilibrium) price of LCC 10.0 and a quantity of 10 shares of ABC Company a buyer and a seller do a deal (via an ATS system which operates on a price-time priority basis). At this point the demand and supply conditions required (price and quantity) coincide. The only other bids that can exist are the unfulfilled (inferior) ones that lie further down the demand curve, for example 40 shares at LCC 9.8. Similarly, the only other offers that can exist are the unfulfilled (inferior) ones that lie up the supply curve, for example 30 shares at LCC 10.2.
Figure 3: buying and selling prices and equilibrium price
Obviously these inferior bids and offers are unfulfilled because the selling prices are above where the buyers wish to buy. Once a deal is done at LCC 10.0 for 10 shares as indicated in Figure 3, the next best bid and offer prices (and quantities) become the superior prices (and are "advertised" on the ATS for all participants).
Let us assume that the next best bids and offers are a bid deal of 40 shares at LCC 9.8 and a supply deal of 30 shares at price LCC 10.2 (see Figure 4). There is no equilibrium price but it can be estimated to be at the mid-point between the bid and offer prices, i.e. LCC 10.0. Given the superior bid and superior offer, the market will now reassess. If they are keen to deal they will most likely adjust their prices to the level of LCC 10.0 and the demander will have his demand for 40 shares partially fulfilled (see Figure 5).
Note that LCC 10.0 is not the actual price received by the seller or paid by the buyer. Transactions costs (commissions mainly) need to be added / subtracted.
Figure 4: "superior" buying and selling prices
Figure 5: deal consummated