Price determination in financial market

Financial markets can be classified by different ways. According to the transaction subject, financial markets are classified as: foreign exchange, money, and securities markets. Many articles on financial theories have expounded in detail on the characteristics, functions, and trading techniques of various markets. The theoretical starting point of this chapter is to explore how an economic subject, relying on an economic power, affects trading prices to realize interest distribution in their own favor. In this chapter, we first analyze the microstructure of financial markets, the nature of the market trading price, and the influencing factors. We then build mathematical models for the determination of trading prices for major financial products. In this process, we reveal that trading prices are determined by power games, and we study the mechanisms in action regarding economic power and the influencing factors.

The microstructure of financial markets

In this section, we analyze the microstructure of foreign exchange markets, money markets, and securities markets. That is, we discuss market participants, participant resources, economic power, and the behavior and consequent impacts on trading price as an ideological foundation for analyzing the nature of the trading price in financial markets and building mathematical models.

Foreign exchange markets

Foreign exchange markets (forex market) are markets connected by intermediary agencies or telecommunications systems through which currencies of different countries are traded. The market can be tangible, as in foreign exchange trading locations, or intangible, such as inter-bank forex transactions via telecommunication systems. Participants in forex markets include import and export companies and multinational corporations because their business activities require foreign currency transactions. Central banks participate in forex markets because exchange rates are a primary economic variable that is prioritized by governments in their economic administration. Participants in forex markets include investor capital held by financial institutions and international fluid capital—funds controlled by investors who actively seek short-term returns.

The amount of resources held by each market participant differs depending on the extent of its economic power. Moreover, there are various channels through which economic power is reflected in the interactions between participants. For example, from an international perspective, a country’s power is embodied by the dependence of other countries on that country. Such dependence may stem from many sources including technology, politics, natural resources, or military resources. Relying on the degree of mutual dependence-that is, the magnitude of economic power-countries will bargain to determine exchange rate trends in the long and medium-run. From a domestic perspective, games exist on the exchange rate between interest groups and the government. The government hopes to achieve economic growth by supporting associated industries with favorable exchange rates. For example, in the 2008 financial crisis, the US government used various means to stimulate appreciation in the RMB—the Chinese currency. The US government wanted to promote US exports and stimulate its manufacturing industry to prevent a recession. For the same reason, domestic interest groups lobbied policy makers for exchange-rate arrangements favorable to them. For instance, export businesses looked forward to depreciation to boost exports while import businesses welcomed appreciation to reduce costs.

Games also exist between international fluid capital and central banks in the forex markets. For example, the 1997 Asian economic crisis was sparked by an attack from international speculators on Southeast Asia’s financial markets. The speculators sold out the currencies of these countries and bought US dollars, which led to a drastic fall in the exchange rates of these currencies and generated huge profits for the speculators. The governments of Indonesia, Malaysia, Thailand, and other countries as well as the central banks in these countries introduced various measures to stable their own currencies, such as increasing transaction costs and interest rates and even purchasing domestic currencies with their forex reserves. International fluid capital resources include huge amounts of cash, valuable information, and skillful speculative techniques. At the same time, International fluid capital took advantage of the disorder of the forex institutions and the slack regulations in these countries. However, the governments in these countries responded to the attack politically and economically. The 1997 economic crisis illustrates the game whereby the agents of interest affect exchange rates via the resources they have on hand to realize their own interests. Therefore, using game theory, the studies on the determination of exchange rates can objectively reflect economic reality.

Money markets

The economic agents in market economies can be characterized objectively as agents with capital surplus and agents with a capital deficit. The driving force behind the emergence and development of money markets arises from the desire to maintain capital liquidity. Money markets satisfy capital demand and provide capital suppliers with profitable opportunities by linking demand and supply with a variety of financial tools. At the micro level, money markets offer flexible administration to banks and enterprises. Money markets provide channels through which monetary policies conducted by central banks control and regulate economies. Additionally, money markets facilitate the development of financial markets.

The interest rate mechanisms of money markets are sensitive to the demand and supply of social capital. Hence, interest rates are an indicator of the position of capital in markets and a measure of the returns on financial products. Because it has the characteristic of price, the interest rate reflects the profitability of the parties involved in transactions. We believe that the interest distribution mechanism is formed as a result of power games and that the interest rate must also be formed on the basis of borrowers and lender negotiations.

For example, since a nation’s central bank is empowered to make and conduct monetary policy and control and manage macroeconomic operations, central banks set basic interest rates on behalf of the government. This fiscal role of central banks affects market interest rates by adjusting the money supply under market conditions to achieve goals such as currency value stabilization and economic intervention. Deposits and loans are the bread and butter of commercial banks and the key functions affecting their profits. The competition between commercial banks for deposits is affected by factors such as the central bank’s benchmark interest rate and the demand for credit macro-level firms.

At the micro level, these factors include the quality of service, network construction, and the marketing efforts of commercial banks. The micro-level factors are subject to the resources controlled by the banks, the bank’s ability to set up extensive outlets to absorb more savings, and the competence of bank employees in attracting additional deposits. With respect to lending operations, commercial banks often provide differentiated financial products to realize profits under market conditions. In this process, banks must understand the operations of similar businesses served by their competitors, investigate borrower’s qualifications as well as the expected returns to projects considering the risk, and engage in loan negotiations. How banks perform in these respects is closely related to the resources controlled by the banks.

Borrowers assume risky investments using bank loans to realize the associated returns. Facing differentiated financial bank products, firms often carefully consider their own qualifications, the prospects for returns on risky projects, and the degree of competition in the banking sector. Based on this information, borrowing firms bargain with commercial banks to secure low-cost loans. In the above process, firms can influence interest rates using their resources and gain favorable results. Hence, these companies garner benefits by influencing the determination of market interest rates.

Securities markets

Securities are issued and traded in the securities markets. These markets reflect and regulate the flow of capital; moreover, they impact overall economic performance. Superficially, securities markets are a trading mechanism that determines securities prices according to the relationship between demand and supply through competition. However, the returns to investors come largely from trading in this market. If some investors can affect the demand and supply, the price of securities will be indirectly affected, even determined. For example, manipulative behavior is common in this market. Relying on capital, information, and technical advantages, manipulators influence investor expectations through market and non-market behavior. This influence is, in turn, transmitted to prices through the demand and supply relationship. The purpose of manipulation is to obtain greater profits. In this process, the fundamental reason manipulators can influence market prices is that they control more resources, such as substantial capital, non-public information, and a professional investment team while market demand and supply simply serve as the means to manipulation and the pursuit of profits. The relationship between demand and supply under free competition cannot conceal the logic that resources provide power, and power is manifested in the transaction price, that is, interest distribution.

Participants in the securities market mainly refer to securities exchanges, securities issuers, securities firms, securities investors, service agencies, regulatory bodies, and trade associations. Since our focus is securities market prices, we analyze behavior patterns, desired interest levels, and the resources of securities investors. Investors are capital suppliers as well as buyers of financial products.

Investors can be classified into two categories: individual and institutional investors. Institutional investors include all types of enterprises, commercial banks, and non-bank financial institutions (such as pension funds, insurance funds, and securities investment funds). Institutional investors’ investment directions, objectives, and sources of capital may differ, but this group typically has some market features in common such as plenty of capital, remarkable capacity to collect and analyze information, the capability to spread investment risks with effective portfolios, and a strong influence on the market. Some institutional investors can affect the market price and trading volume through resource advantages and may even create fictions in the market to induce other participants to trade in securities either to profit or transfer risks. In this process, institutional investors are the main price setters in the market. Market manipulation has a long history of various strategies. Section “Capital, information, and the determination of securities pricing” provides a detailed discussion on manipulation. Individual investors are the majority of investors in the securities markets, and their main goals are to insure and increase the value of capital. Compared with institutional investors, individual investors possess less capital, rely on lagged information, have little effect on the transaction price, and are price takers in the market.