Price discovery

The price discovery process (also called price discovery mechanism) is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers.The futures and options market serve all important functions of Price Discovery. The individuals with better information and judgement participate in these markets to take advantage of such information. When some new information arrives, perhaps some good news about the economy, for instance, the actions of speculators quickly feed their information into the derivatives market causing changes in price of derivatives. These markets are usually the first ones to react as the transaction cost is much lower in these markets than in the spot market. Therefore these markets indicate what is likely to happen and thus assist in better price discovery.

Price discovery is different from valuation. Price discovery process involves buyers and sellers arriving at a transaction price for a specific item at a given time. It involves the following:

"Market" is a broad term that covers buyers, sellers and even sentiment. A single market will have one or more execution venues, which describes where trades are executed. This could be in the street for a street market, or increasingly it could be an electronic or "virtual" venue. Examples of virtual execution venues include NASDAQ, The London Metal Exchange, NYSE, London Stock Exchanges.

After the 2001 Enron scandal, the Sarbanes–Oxley Act tightened accounting rules regarding the "mark to market" method, requiring that only recently discovered prices be used. The intention of this change was to stop companies overvaluing the assets they held. Each night (or reporting period) they would have to take a recently discovered market price obtained from two or more market observers.

Recent changes in market regulations, post Lehman Bros, have outlined practices that affect the price discovery mechanism. Price discovery is sensitive to many factors. Consider for a specific execution venue the following inputs drive the price discovery mechanism.

The cost of execution applies to all markets, even a street market trader may have to pay to have a stall, or invest time walking to a village market. These are not costs of production but a cost incurred to access the execution venue.

Remember that price discovery is a summation of the total market's sentiment at a point in time: a multifaceted, aggregate view on the future. It is how every price in every market is determined. The market price is important as it is a factor in the pricing at off market execution venues and direct and indirect derived products. For example, the price of oil has a direct bearing on the cost of tomatoes in cold climates.

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