April 02, 2025
6 mins read
The process through which asset prices are determined in a market is called price discovery. It involves several buyers and sellers participating in a market and negotiating Read more..about an asset’s price. Through such interactions and negotiations, an asset’s market price is determined. While the process of price discovery is the result of interactions between buyers and sellers, the process of valuation involves finding out the fair value of an asset using methods like discounted cash flows, etc. Hence, price discovery and valuations are two different concepts. Read less
Price discovery is the process of finding the market price of an asset through interactions between its buyers and sellers. Hence, price discovery is one of the most important functions performed by markets.
As a significant number of buyers and sellers interact to negotiate an asset’s price, it leads to price discovery. It is almost impossible to gauge the fair value of an asset without its price being discovered in a market.
When buyers and sellers interact, they assess several tangible and intangible factors about an asset, like its demand and supply, the risk attitudes of market participants, and the overall financial and political scenario.
Through the process of price discovery, buyers and sellers agree on a price, which results in a transaction.
The price discovery of any asset cannot happen without the forces of demand and supply coming into play. A financial market provides a platform to bring buyers and sellers of various kinds of assets together.
These buyers and sellers create demand and supply, respectively, for an asset. However, they often have different reasons to trade and also different styles of trading.
For example, a buyer may be keen to purchase an asset because he thinks its price will rise in the future. Hence, he creates demand. However, a seller wants to sell the very same asset because he thinks that its price has already risen too much. So, he provides the supply.
A market helps buyers and sellers interact with each other by creating the forces of demand and supply. Through these numerous interactions, a consensus price is agreed upon to facilitate a transaction.
All buyers and sellers, however big or small they are, play a role in the price discovery of an asset. And, this process is happening all the time an asset trades.
At times, buyers and sellers may not be even consciously aware of it, but the process of price discovery keeps on happening to set the next price. Hence, it is very important and is at the heart of all markets.
Volatility means the extent to which an asset’s price changes over a period of time. In extremely volatile markets, prices move up and down rapidly, which can be due to many reasons, like economic changes, investor sentiment, etc.
There are traders who avoid transacting in an asset if its price is highly volatile. On the other hand, some traders become active, especially when price volatility is high.
If prices are extremely volatile, it becomes difficult to gauge the fair price of an asset because the price changes rapidly from one moment to the next. Hence, the uncertainty increases, which can even result in losses for some traders.
So, when the price volatility is very high, traders may be reluctant to take a decision, which may lead to wider bid-ask spreads as well.
People often get confused between price discovery and valuation. Although these both are financial terms, they are fundamentally different from each other. So, please refer to the table below to have a clear understanding of the differences between them:
Criteria | Price Discovery | Valuation |
Meaning | The process through which the price of an asset is determined based on the interactions between its buyers and sellers is called “price discovery.” | The process of valuation means finding the true or fair value of an asset using various methods, such as the discounted cash flow (DCF) method, etc. |
Market-driven or model-driven | Price discovery is driven by the forces of demand and supply, which prevail in a market. Hence, it is a market-driven process. | The process of valuation is based on a model that is used to calculate an asset’s fair value. For example, you can use multiples like price-to-earnings or the DCF method for this purpose. In other words, valuation is model-driven and not market-driven. |
Importance | Price discovery is important because it tells us about the correct price of an asset. Needless to say, an asset’s correct price is the price that market participants are willing to pay for it. | Valuation tells us what the fair price for an asset should be. If there is a huge gap between the market price and the fair price of an asset, it can provide you with trading opportunities. |
The process of price discovery is extremely important for the smooth functioning of markets. Traders are constantly assessing the fair price of an asset, which can only be determined through the process of price discovery.
Price discovery cannot ensure that an asset trades at its fair price all the time. However, it can ensure that an asset’s market price inches towards its fair value through numerous interactions between buyers and sellers.
By comparing a share’s current market price (which is determined through price discovery), market participants can also find out whether it is over or under bought. If it is overbought, it shows that its current price is more than its fair value.
Conversely, if it is underbought, it reflects that its current price is lower than its fair value. In simple words, price discovery enables buyers and sellers to find out whether the current market price of an asset is fair for both of them or not. Based on that analysis, they decide their course of action.
If you are keen on financial markets and are about to open your trading account, you must develop a thorough understanding of the process of price discovery. It will help you appreciate how prices are determined in the market. You will also realize your own role in price determination through this process.
Along with understanding the concept of price discovery, you must also learn a few valuation methods, which will help you arrive at the fair value of a share. By comparing a security’s market price with its fair value, you will be able to decide whether to buy or sell it.
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The process of price discovery helps you arrive at the market price of an asset through an interplay between its demand and supply. However, valuation involves calculating the fair value of an asset based on factors like expected cash flows, etc.
The forces of demand and supply help us find out the market price of a security. If an asset’s demand is higher than its supply, its price will likely increase. Conversely, if its supply is more than its demand, it may cause a drop in its price.
Price discovery helps in finding the market price of assets through several interactions between buyers and sellers. Over a period of time, it also results in assets trading either at their fair value or almost at their fair value.
Some of the most important challenges that are faced in the process of price discovery are extreme market volatility and the lack of liquidity for an asset.
Extreme market volatility causes sharp ups and downs in prices, which makes it difficult to gauge the fair price for an asset, ultimately causing some traders to become reluctant about participating in the market.
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