The Concept of Price Formation
in Stock and Forex Markets


 

Unveiling the Secrets - How is the Price Formed?

It is only natural that price formation process is interesting for just about anybody. And it is not important whether you want to buy potatoes or shares of an oil company - the matter of prices is always relevant, especially for those working in financial markets. And if you have any questions regarding why and how the prices change and form you will find the answers in this article. Well, let us begin!
 
Price formation is one of the key elements of market economy functioning. The price of a commodity or a service is formed as a result of numerous economic, political and social processes and this is true for traditional commodity relations as well as for financial markets.

Centralized and Market Aspects of Price Formation

We commonly distinguish between two major aspects of price formation: centralized and market ones.
 
In the context of stock and currency markets the market price formation based on the principle of demand and supply is considered a priority. In other words the price of a currency or a security constitutes a sum that a buyer is willing to pay for it.
 
However, elements of centralized price formation are not alien to financial markets, since large participants of economic relations can influence the price of trading instruments much more than the demand of private investors. For example, actions of central banks such as currency interventions, liquidity increase or key interest rate decrease have a great influence on Forex instruments' price formation. And the stock market depends on decisions of emitters that issued the securities, initial price, goals and price formation strategy.

The Concepts of Expenditure Cost and Monetary Basis of the Price

One of the main theories of price formation is based on the fact that each commodity has its price reflected by an abstract labor spent on its creation. But economic analysis of price formation in financial markets is complicated by the fact that it is impossible to calculate the expenditure cost for a currency or a security.
 
Whereas for traditional commodity relations between a buyer and a seller the expenditure cost concept is applicable and rather convenient, it is, in essence, useless for financial markets. A seller of a particular material commodity can calculate how much abstract labor was spent on its production but in regard to securities and currencies this method does not work. Though I think there is one exception to this rule - a calculation of a share's initial cost to which the emitter includes the cost of issuing and registration.
 
But on the whole, the other concept is in effect in financial markets - monetary basis of the price which presumes the price formation under the influence of demand and supply mechanisms. In the context of stock market and the foreign exchange market this concept is more relevant since it shows the dependency of price on buyer's subjective evaluation and determines the price as a result of a standoff by two sides - sellers and buyers.
 
In order to understand the price formation mechanisms in financial markets we need to understand who is taking part in the trading process. The stock market is mostly represented by emitters that in this context are closer to sellers, and investors. An emitter is an organization that issued its securities to the market and an investor is an individual or a corporation acquiring these securities, as a rule with the aim of their subsequent resale. Moreover, investment companies and funds also take part in stock market instruments' price formation.
 
The major currency exchange participants are central banks, hedge funds, brokers and other intermediary organizations, as well as private investors. I consider an important moment in comprehending the price formation mechanism in the currency exchange market to be the understanding that each Forex participant can switch from buyer's position to seller's one and back at any time. That is why we cannot talk about contrary interests of a buyer and seller in the context of FX market. An important role is played by objective factors as well as subjective evaluation of a currency by market participants, their fears and expectations. Frequently, an asset may be overestimated or underestimated due to some psychological factors and price fluctuations are a result of aggregate opinion of market participants which influences the demand curve.
 
In its turn the stock market presupposes a higher objectivity in price formation, since the main price elements are set by emitters before the securities are issued and released onto the market and become available to investors. If we are talking about the initial market, then the emitter makes a decision regarding the initial offering price, redemption price and, as a rule, date of redemption. As I said before, in this case the emitter includes the emission costs into the price. In the initial market the price formation opportunities are rather limited unlike the secondary market which is unlimited in space and subsequently allows the securities' prices to form in accordance with market factors - supply and demand.
 
On the one hand it is essential for a constant supply of various securities to be in the stock market, and on the other hand there must be an active demand for them. The balance of supply and demand forms the real asset price, but it is often the case when the price is overestimated because of unsatisfied demand or underestimated because of excessive supply. Competition also plays its role in price formation in the stock market - thus, for example, if a monopoly is developing in the market, then it forms a decreasing tendency for the emitter's securities.

Objective Factors of Price Formation in Forex

As I noted before, the price formation in the currency exchange is influenced by objective and subjective factors. The subjective ones include political, economic and social factors, namely the interest rate, volume of gold reserve which is a guarantee of the currency's stability, indicators of GDP, industrial and business activity, internal and external demand, employment and inflation. As a rule, traders also pay attention to stock indices (e.g. DAX 30 for Germany or Dow Jones for the US) since their growth indicates the price increase of the country's leading companies' shares, and their fall means the decrease of the share prices. There is also a concept of force-majeure. It can be regarded as both, objective and subjective price formation factor. In case of political or ecological force-majeure foreign investors begin withdrawing their assets from the country which weakens the national currency. But often the reason for rapid price fluctuations is not the negative consequences themselves but market participants' expectations.

The Role of Subjective Factors in Price Formation

Recently we can see the role of expectations in the currency exchange growing. The decisions on buying and selling are made by investors on the basis of the future price forecasts which, in essence, play the role of "self-fulfilling prophecies" since the traders support their forecasts with their actions using substantial borrowed funds. With margin trading used by traders to increase the invested funds the aggregate influence of private investors on the price of a trading instrument has increased significantly.
 
This mechanism can be easily explained by an example. Market participants know about a planned for a certain time release of important macroeconomic data that will influence the price of a certain Forex instrument. They suppose that the data will be positive and start acting beforehand - buying currency they think will grow. Market participants themselves create an increased demand for a currency, which leads to its growth. In the end it is hard to say what caused the currency price growth - the fundamental factor itself or the actions of the crowd.
 
I consider mob psychology to be one of the most important elements of price formation in Forex due to the fact that theory is often powerless against the mass of investors that form the main trend. Reasoning from the fact I included a thesis in my theory "Forex Chart is Alive!": "a trader shall neither go counter to the crowd nor follow it inviolately". In most cases the ones who can go counter to the crowd and benefit are market-makers and hedge funds while blindly following a trend can lead to trader's tardy reaction to market signals.
 
Price formation in the stock market is also influenced by subjective factors: emitter's rating and reputation, expectations and needs of investors. Here we have the notion of price formation strategy which is used by every emitter. This strategy can be quick profiting, market penetration or covering a particular segment. Different goals pursued by emitters lead to different ways of initial offering price formation.
 
Price formation in the stock market is easier to analyze, since an exchange of a given country often has specific space boundaries and single trading rules. Due to the fact that Forex is an off-exchange market and has no univocal regulations applicable everywhere in the world there is no benchmark or real price. Every company offering intermediary services in the currency exchange and each trading terminal have their own rules, and accordingly their own prices. It comes as no surprise that a price of any currency provided by different terminals at the same time period can be different.
 
The majority of transactions in Forex are conducted through ECN trading systems that comprise several banks. Systems of this type are the ones providing information to brokers who in turn provide it to traders. As a result a benchmark price that would be effective for the whole of FX market simply does not exist, since every bank can place their own quotes and ECN can change the quotes to its own favor to receive profit.
 
Thus, when studying the matter of price formation in the stock and foreign exchange markets you need to remember about the concept of monetary basis of the price, the roles of objective and subjective factors in the price formation of financial market instruments. Moreover, I consider the subjective factors to require a more thorough and all-around analysis, especially in the context of the foreign exchange market.

Konstyantyn Kondakov

About the author: Konstyantyn Kondakov is the author of two books on how to trade in the Forex market. His first book "MetaTrader 4: Learning to Earn on FOREX" was published in 2011. It describes in details all stages of the trading platform - from installation of a trading terminal to testing expert advisors. All material is laid out simply, accessibly and understandably. The focus is on representation of all processes in MT 4. In addition, the manual provides multiple examples of how to use new instruments of the terminal in practice. Konstyantyn has written and published his second book "How to See and Forecast the Market: Forex Fundamental Indicators". In this book the author tells readers about all the nuances of the fundamental analysis of the Forex market.