What Is Price Discovery?
Price discovery is the overall process, whether explicit or inferred, of setting the spot price or the proper price of an asset, security, commodity, or currency. The process of price discovery looks at a number of tangible and intangible factors, including supply and demand, investor risk attitudes, and the overall economic and geopolitical environment. Simply put, it is where a buyer and a seller agree on a price and a transaction occurs.
Understanding Price Discovery
At its core, price discovery involves finding where supply and demand meet. In economics, 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 transaction size to background conditions of previous or future scarcity or abundance. Location, storage, transaction costs, and buyer/seller 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.
While the term itself is relatively new, price discovery has been around for millennia as a process. Ancient souqs in the Middle East and market places in Europe, the Indian subcontinent, and China brought together large collections of traders and buyers to determine prices of goods. In modern times, derivatives traders in the pits of the Chicago Mercantile Exchange (CME) used hand signals and verbal cues to determine 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 with regard to large positions.
Price Discovery as a Process
Rather than consider price discovery to be a specific process, it should be considered the central function in any marketplace, whether it be a financial exchange or the local farmer's market. The market itself brings potential buyers and sellers together, with members of each side having very different reasons for trading and very different styles for doing so. By allowing all buyers and sellers to come together, these marketplaces allow all parties to interact and by doing so a consensus price is established. Without knowing it, 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 can 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 and therefore can change the price at which both sides are willing to trade. However, 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. Where price discovery is a market-driven mechanism, valuation is a model-driven mechanism. Valuation is the present value of presumed cash flows, interest rates, competitive analysis, technological changes both in place and envisioned, and many other factors.
Other names for valuation of an asset are fair value and intrinsic value. By comparing market value to valuation, some analysts can determine if an asset is overpriced or underpriced by the market. Of course, the market price is the actual correct price, but any differences may provide trading opportunities if and when the market price adjusts to include any information in the valuation models not previously considered.
Compete Risk Free with $100,000 in Virtual Cash
Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of Investopedia traders and trade your way to the top! Submit trades in a virtual environment before you start risking your own money. Practice trading strategies so that when you're ready to enter the real market, you've had the practice you need. Try our Stock Simulator today >>