Chapter 4: Price Discovery

What makes stock prices go up and down? Most people would tell you that supply and demand makes stock prices go up and down, and most people would be wrong. Price discovery is the actual reason tha makes stocks go up and down and is a difficult concept to understand that is too often comapred with supply and demand. Although the two are simliar, they are not the same. To technically prove supply and demand wrong as the reason that stocks go up and down, think about a supply and demand graph. The supply and demand curves can increase/decrease, but when a company issues a share count for their company, the number they issue is a FINITE number of shares. This means that supply can’t increase because there is not unlimited amounts of shares available, only the amount that the company has issued. Price determination (supply and demand) is the interaction of the broad forces that determine the market price level, not the market price. This is where we move to price discovery. Price discovery is the process of buyers and sellers arriving at a transaction price for a given quality and quantity of a product at a given time and place. Price discovery involves a few concepts: market structure (number, size, location, and competition between buyers and sellers), market behavior (pricing and obtaining methods), market information (amount, reliability), and futures markets and risk management alternatives. Price discovery begins with the market price level. Because buyers and sellers discover prices on the basis of uncertain expectations, transaction prices fluctuate around that market price level. Because of information uncertainty and for lack of a better term just differing opinions, buyers and sellers never truly know the real price of the product. Therefore, buyers are willing to bid and sellers are willing to offer different prices on any given day. Since we have learned about both supply and demand and price discovery, we can articulate how they both relate to stock prices.

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