Peter G. Schick Professor of Finance, University of Missouri–St. Louis
Assistant Professor of Finance, Governors State University
Price discovery is the process of incorporating information permanently into price. Price discovery is distinguished from price movement or price impact in that observable price changes include both a permanent component and transitory price changes. While the former component represents a shift in the fundamental value of an asset, the latter is brought about by market frictions, such as bid-ask bounce, inventory adjustments, and order imbalances.
In general, price discovery efficiency is greater either when an asset or market incorporates more information into price for a given time interval or when a fixed level of information is incorporated into price faster. Yet, price discovery efficiency is affected by different assets having varying market structures such as different trading platforms (e.g., open outcry versus electronic limit order market), regulatory conditions, and proximity to information flows. Also, markets may have different transaction cost structures, liquidity conditions, and transparency. These dissimilar conditions then lead to the relative benefiting or handicapping of informed traders, who thus incorporate information into price at different speeds and extents. Thus, different market structure inputs lead to varying ...