In plain English
Markets are places where claims on future cash change hands. Prices are just the market's current guess at those cash flows and their risk.
The advanced view
Market microstructure determines how quickly information becomes price: bid-ask spreads compensate market makers for adverse selection, depth determines impact, and liquidity premia show up as yield. Efficiency comes in degrees — weak, semi-strong, strong — and the practical claim is not that prices are right, but that they are hard to beat after costs.
Fixed income first, because it is where discounting becomes mechanical. A bond's price is the present value of coupons plus principal. Price and yield move inversely. Duration measures price sensitivity to rate changes; DV01 converts it into a currency amount per basis point. Convexity captures the curvature that duration misses on large moves.
Bond price = Σ [C / (1+y)^t] + F / (1+y)^n ΔPrice % ≈ −Modified duration × Δy DV01 ≈ Modified duration × Price × 0.0001 Forward rate: (1+s2)² = (1+s1) × (1+f1,2)
The yield curve encodes expectations of rates, inflation and term premia; inversion has historically preceded recessions. On the equity side, prices are the present value of expected dividends or free cash flow; the Gordon growth model is the compact version. Market microstructure — bid-ask spreads, depth, order types — determines what you actually pay versus what the screen shows.
Essential vocabulary
- Yield to maturity
- The single discount rate that sets the bond's present value equal to its market price. An IRR for bonds.
- Credit spread
- Yield over the risk-free benchmark, compensating for default risk and illiquidity.
- Efficient Market Hypothesis
- Prices reflect available information. The debate is about degree, not binary truth.
- Liquidity
- Ability to trade size without moving the price. Priced in spreads and in the discount applied to private assets.
Intuition
Market prices are the consensus discounted-cash-flow model. That is why the interesting question is never 'what is it worth?' but 'what does this price already assume, and where do I disagree?'. Efficiency is a matter of degree: information gets into prices at different speeds for different assets.
Common pitfalls
- ×Treating any excess return as skill without adjusting for risk exposure.
- ×Assuming liquidity when the security trades thinly — the quoted price is not the exit price.
- ×Confusing a forward rate with a forecast; it is an arbitrage condition.
Worked example — implied expectations
Step 1 of 4
- 1Share price 40, next-year EPS 2.0 → P/E 20×
Why it works
Arbitrage enforces the pricing relationships. If two portfolios pay the same cash flows in every state and trade at different prices, someone buys one and sells the other until the gap closes. Almost every pricing formula in finance is a formalised version of that single argument.
How it is used — reading a quote in a case
Step 1 of 4
- 1A bond quoted 98.50 / 98.70 with a 5-year maturity and 4% coupon.
Deeper
Deeper: yield curves, no-arbitrage and market microstructure
Prices in liquid markets are set by no-arbitrage, not by opinion. Forward rates fall out of spot rates: (1 + s₂)² = (1 + s₁)(1 + f₁,₂). Currency forwards fall out of interest differentials (covered interest parity). If a quoted price disagrees, either you have missed a cost (funding, collateral, taxes, transaction) or there is an arbitrage — usually the former.
Curve shape carries information. Upward sloping is the normal state (term premium plus growth expectations); inversion has preceded most recessions because it prices near-term policy cuts. In an interview, read the curve as a forecast the market is making, then ask whether the company's financing plan is consistent with it.
Must know cold
- ✓Forward rate from spots: (1 + s₂)² = (1 + s₁)(1 + f).
- ✓Covered interest parity: F = S × (1 + r_dom) ÷ (1 + r_for).
- ✓Bid-ask spread and depth are the real cost of trading, not the commission.
- ✓Efficient-market forms: weak (prices), semi-strong (public info), strong (all info).
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
One-year spot 3%, two-year spot 4%. What is the implied one-year rate a year from now?
Exercise 2
Spot 10.50 SEK/USD, SEK 4%, USD 5%, one year. What is the fair forward, and which currency is at a discount?