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Unit 2: Elements of Financial Markets: Price Determination and Discovery

The document discusses key elements of financial markets including price determination, price discovery, information aggregation and coordination, risk sharing, liquidity, and efficiency. Price determination refers to general market prices while price discovery is the specific agreed upon price between buyer and seller. Technology has allowed for very fast trade execution and widespread information sharing. Risk sharing involves distributing risk among multiple parties. Liquidity refers to how easily an asset can be converted to cash. Efficiency means prices reflect all available information.

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270 views

Unit 2: Elements of Financial Markets: Price Determination and Discovery

The document discusses key elements of financial markets including price determination, price discovery, information aggregation and coordination, risk sharing, liquidity, and efficiency. Price determination refers to general market prices while price discovery is the specific agreed upon price between buyer and seller. Technology has allowed for very fast trade execution and widespread information sharing. Risk sharing involves distributing risk among multiple parties. Liquidity refers to how easily an asset can be converted to cash. Efficiency means prices reflect all available information.

Uploaded by

chiransh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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MScFE 560 Financial Markets – Notes (2) Module 1: Unit 2

Unit 2: Elements of Financial Markets


Thus far, our examination of financial markets has primarily focused on distinguishing and
understanding various features that make up and drive how financial markets work. Here, we turn
our focus to additional aspects that are not only by-products of the markets but also driving forces
behind them.

Price determination and discovery


One of the underlying principles of market systems is that there must be an agreed-upon value
attributed to a good or service. Price determination and price discovery refer to two processes
according to which such a value may be set.

Price determination refers to the broader market price of a security, good, service or other
instrument that is determined by the general level of what buyers are willing to pay and what
sellers are willing to earn. This is affected by the general demand vs supply for the instrument.

Price discovery is the more specific agreement between buyer and seller in relation to the market
context at the time of the trade. The instrument may be in high demand, or in excess supply. It may
be of high quality in relation to its counterparts, or it may be of poor quality. These and other
factors have an effect on the price of the specific instrument in question.

Think, for example, of how you would sell a car. First, you might establish the price by determining
what other similar cars are sold for. Then, once a buyer has shown interest, you and they would
determine a price based on the specifics of the car.

Information aggregation and coordination


In financial markets, the speed and accuracy with which information can be delivered to market
participants has a direct effect on the returns that can be made. It is no wonder that the areas
surrounding the NYSE (New York Stock Exchange) have some of the most advanced processing
technologies in the world. A trade can be executed in less than half a millionth of a second – more
than a million times faster than a human being can make a decision – because technology has
automated each step from order to payment.

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MScFE 560 Financial Markets – Notes (2) Module 1: Unit 2

Not only are trade speeds fast, but quantitative trade data is also easily and cheaply displayed on
platforms throughout the world for anyone to access in real-time. Simply by visiting a website,
anyone can see spot (real-time) prices for almost any publicly traded financial product or
instrument available. The intense competition of the markets drives the development of these
technologies and information platforms, which in turn fuels more efficient, competitive markets.

Risk sharing
Risk sharing refers to the division of risk among more than one party so as to minimize the impact
of loss. Another characteristic is that the risk is shared among those who have similar or equal risk
of loss. It differs from insurance, which involves the transfer of risk from one party to another.

In traditional insurance, the associated risk is assumed to be known and, because the risk is known,
the insurer can calculate, and therefore charge, a premium which the risk-averse party is willing to
pay. Risk sharing differs from traditional insurance products in that the probability of loss is not
fully known (as in the case of a new product).

For example, if a client (institution or government) requires a substantial loan from a bank, the
bank may approach other banks and request that they assist with the risk by funding a portion of
the loan each. This prevents the original bank from taking on the full risk of loss in the event the
client defaults on their debt repayments.

Liquidity
Liquidity refers to the ease with which an asset can be converted into useable tender (cash
mainly). It is an important concept in financial market practices, as it enables market participants
to achieve their desired goals. Buyers and sellers want to be able to convert their product into
cash as quickly as possible in order to meet the profit incentive (for investors in equity markets) or
the borrowed principal sum (for lenders e.g. in the bond market) that motivated them to approach
the market in the first place. This can only happen in a market arena that is constituted by
efficiency of processes, shared information and availability of funds.

Where a market is illiquid, buyers and sellers are at risk of loss due to the time exposure involved.
The recent boom and subsequent sell-off in crypto-currencies is a good example. During the sell-
off period, there were so many sell-side instructions that exchanges were neither able to process

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MScFE 560 Financial Markets – Notes (2) Module 1: Unit 2

them in time nor match the sell-side to an appropriate buy-side order. This left crypto traders
sitting on their hands unable to trade, as they watched the value of their holdings dwindle. 15

By the time their trades were processed, their losses were exacerbated due to the illiquidity of the
market or exchange.

Efficiency
Efficiency in a financial context refers to the fact that the specified prices reflect all available
information regarding the particular instruments, making it impossible for participants to
outperform the markets over time. The Efficient Market Hypothesis (EMH) states that: “asset
prices fully reflect all available information. A direct implication is that it is impossible to ‘beat the
market’ consistently on a risk-adjusted basis since market prices should only react to new
information or changes in discount rates (the latter may be predictable or unpredictable).” Though
the theory is by no means watertight, it draws our attention to an important aspect of price setting
in the global financial market: that prices are driven upward or downward to the point at which
the available information reflects an equilibrium price.

In practice, let’s look at an example below:

If two different exchanges, the NYSE and the LSE, offered the same stock ABC Ltd on their
platforms, and the NYSE sold ABC Ltd stock for $10, but the LSE sold ABC Ltd stock for $10.50, it
could be assumed that the market could simultaneously buy up the cheaper ABC stock on the
NYSE and sell it for more on the LSE.

This buying of shares on the NYSE would – through forces of supply and demand – drive up the
price of ABC Ltd on the NYSE, while the selling of ABC Ltd on the LSE would drive down the price
on that exchange. This would go on until the prices find equilibrium. This example – which is an
example of arbitrage - gives a good indication of the efficiency of the market in practice.

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