Introduction
Book Building is a method of pricing the shares. It is the process which is the most common process for issuing share. It is usually considered disadvantageous for the shareholders most of the share pricing is now done via the book-building process. In book building the company mentions the floor price and not the ceiling price. The ceiling price is determined depending on the demand of the share in the market during the IPO Process.
What Is Price Discovery?
Price Discovery is the overall process for setting the spot price or the proper price of an asset, security, commodity or currency. It looks at the number of tangible and intangible factors, including supply and demand, investor risk attitudes and the overall economic and geopolitical environment. Simply put it is the price at which the buyer and the seller agree and the transaction occurs.
How Does Price Discovery Function?
Price Discovery helps the buyers and sellers to set the market prices of the tradable assets. It is because of the mechanism of price discovery set out what sellers are willing to accept and what buyers are willing to pay. Due to this price discovery is concerned with finding the equilibrium price that facilitates the greatest liquidity.
Price Discovery matches buyers and sellers based on the number , size , location and competitiveness of the asset. One of the way of how different factors are determined is through auctions. Auction markets enables the buyer and seller to compete till the market price is found. At this point the market will be highly liquid as buyers and sellers match easily.
Which Factors Determine Price Discovery
The below mentioned factors describe about price discovery level
- Supply and Demand
- Attitudes to Risk
- Volatility
- Available Information
- Market Mechanism
1. Supply and Demand
Supply and Demand are the two greatest factors that determines asset price and dictate how crucial price discovery mechanism are for traders. If the demand is higher than supply, the price of the asset will increase for the buyers who are willing to pay more due to scarcity which in turn favors the sellers. At the same time if the supply is higher than demand then the buyers won’t buy the asset as it will be easily available in the market.
In the market when the supply and demand are equal , then the price is said to be in equilibrium as there is an equal number of buyers and sellers meaning the price are fair to both the parties. Price discovery enables the traders to determine whether the buyers or sellers are dominant in a market and what is fair market price.
2. Attitudes to Risk
A buyer or seller attitude to risk can greatly affect the level at which the price is agreed. If the buyer is willing to take on the risk of a fall in the price for the potential reward of a large rise in price they might be willing to pay additional in order to secure their position. This means that the price is set higher than the assets intrinsic value and the asset is overbought and can fall in the coming days or weeks. Risk can be calculated through a risk and return reward ratio and it is important for both buyers and sellers to keep their risk to an acceptable level. It can be done by using stop limits on the active positions.
3. Volatility
Volatility is linked to risk. Volatility is one of the factors which determines whether the buyer choose to enter or close the position in any particular market. Some traders actively seek out volatile markets as they offer potential for large profits. However there are chances such traders incur loss. Traders however can speculate on markets rising as well as falling. This means that they have the opportunity to profit even the markets are bearish.
4. Available Information
The amount of information available can determine the levels at which they are willing to buy or sell. For example buyers may wish to wait to get some key information about the market announcements. This in turn increases demand or supply which means the asset price might change in line with any changes that occur in the market.
5. Market Mechanism
Price discovery is not same as valuation. Price discovery works off market mechanism which seek to establish the market price of an asset rather than its intrinsic value. As a result price discovery is more associated with what buyer is willing to pay and a seller is willing to accept , rather than the analytics behind an asset. In this way price discovery is more reliant on market mechanism such as the microeconomic supply and demand. With price discovery investors have confidence that the price is being quoted at the true market price. This reduces uncertainty surrounding an assets price in turn and that increases liquidity and also reduces cost.
Why Price Discovery is Important in Trading?
Price Discovery matters in Trading because demand and supply are the driving forces behind the financial market. In such cases market is constantly in a state of bearish or bullish flux, it is important here to continuously check whether a stock, commodity index or forex pair is overbought and whether its price is fair to buyers and sellers
By assessing this, the investor or trader can assess whether an asset is currently trading above or below its market value and they can use this information as the basis of whether to open a long or short position.
Price Discovery V/s Valuation
Valuation is the present value of presumed cash flows, interest rates, competitive analysis, and technological changes. Valuation is also known as fair value and intrinsic value. By comparing market value to valuation, analysts determine if an asset is overpriced or underpriced by the market. Market price is actual correct price but any differences may provide trading opportunities.
Price discovery is not the same as valuation. 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.
Price Discovery Example
In the chart below demand is decreasing as supply is increasing. Typically this means an asset’s price will fall. As the graph shows, the two lines representing demand and supply eventually cross, representing a level that both buyers and sellers agree is a fair market price for an asset. As a result, the asset will begin to trade at this level until there is a shift in the levels of supply and demand, which will require another period of price discovery.
Conclusion
Price discovery is the means though which an asset’s price is set by matching buyers and sellers according to a price that both sides find acceptable. It is largely driven by supply and demand. It is useful mechanism to gauge whether an asset is currently overbought or oversold. It can help you assess whether buyers or sellers are dominant in any one particular market.
Frequently Asked Questions (FAQs): -
The price discovery phase refers to the process in financial markets where buyers and sellers interact to determine the market price of an asset. During this phase, the forces of supply and demand come together to establish the equilibrium price at which transactions occur.
After the price discovery phase, the determined price becomes the prevailing market price. This price serves as a reference point for future trades and reflects the collective perception of market participants regarding the value of the asset. Trading continues based on this established price level.
Several factors affect price discovery, including supply and demand dynamics, market liquidity, investor sentiment, economic indicators, geopolitical events, and market participants’ expectations and behavior. These factors can influence the buying and selling decisions of market participants, thereby impacting the equilibrium price.
The different methods of price discovery include auction-based methods, such as open outcry or electronic trading platforms, where buyers and sellers place bids and offers to establish prices. Additionally, in certain markets, price discovery can occur through continuous trading mechanisms, like order matching algorithms, where trades are executed based on predefined rules.
