The Dynamic Process of Price Discovery in an Equity Market

Abstract

We demonstrate that the process of discovering efficient values in equity trading introduces noise in prices. Noise plays an important role in theoretical microstructure literature, and empirical studies have documented high, U-shaped intra-day volatility that is a manifestation of noise. While implicit transaction costs and the tactical trading of informed participants in an asymmetric information environment are contributing factors, they do not provide a sufficient explanation. Accordingly, we focus on an additional factor - price discovery. Our formulation, which allows investors with divergent expectations to respond rationally to each others' valuations, implies elevated volatility even when information is common knowledge.