Tuesday, April 28, 2009

prices as information sources

The usual description of market assumes that every trader wishes to purchase or sell a known quantity at each possible price. ALL the traders come together, and in one way or another a price is found that clears the market-i.e., makes the quantity demanded as close as possible to the quantity supplied.
This may or may not be an adequate description of the market for consumer goods, but it is clearly inadequate when describing security markets. The value of any capital asset depends on future prospects that are almost always uncertain. Any information that bears on such prospects may lead to a revised estimate of value. the fact that a knowledgeable trader is willing to buy or sell some quantity of a security at a particular price is likely to be information of just this sort. Offers to trade may thus affect other offers. Prices may both clear markets and convey information.
The dual role of prices has number of implications. For example, is behooves the liquidity-motivated trader to publicize his or her motives and thereby avoid an adverse effect on the market. Thus an institution purchasing securities for a fund intended to simply hold a representative cross section of securities should make it clear that it does not consider the securities under-priced.

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