Price discovery in securities markets

Abstract

I n his well-known beauty contest analogy, John Maynard Keynes [ 19361 compared securities markets to a newspaper competition where participants must choose, from one hundred pictures, the six faces that other participants in the competition will on average consider the prettiest. The problem as Keynes states it is that “each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.”’ The outcome of the beauty contest in the securities markets is given by the values security prices attain at some future time. But the quality of the prices set by the market in the current period is also a matter of concern. As investors turn to the markets to trade, they do not know with certainty what the current transaction prices are, could never know what the transaction prices might have been had they changed the price, size, type, or timing of their order, and, accordingly, will never know after any transaction whether the price of the execution was fair. Economists generally have believed (externalities aside) that prices set in markets involving many buyers and sellers are fair. A fair price in the securities markets is one that accurately reflects the demand