We often hear this phrase in the world of finance. What does it mean to « price » a certain event, and why is it important to understand?
« Pricing » means « giving a price » to an asset or currency, for example. The price of a currency, such as the euro against the dollar, reflects many variables. One of these variables is the level of interest rates. If interest rates are low in the eurozone compared to interest rates in the United States, capital will tend to flow to where rates are high, i.e., to the United States. This means that demand for dollars will increase and demand for euros will decrease: the euro will therefore depreciate against the dollar. In this context, a fall in interest rates in the eurozone when rates in the United States remain unchanged will theoretically be accompanied by a fall in the euro on the foreign exchange market (depreciation). We would then say that the market is « pricing in » the fall in rates.
Let’s stick with the example of an event relating to interest rates and exchange rates. Interest rates are linked to the monetary policy decisions of the European Central Bank (ECB). The ECB decides to lower or raise its key rates, which then impacts the rest of the economy’s rates under normal circumstances. If the market does not anticipate a decision by the central bank to lower interest rates, it will react immediately to the decision and the pricing will be immediate. If it largely anticipates the central bank’s monetary policy decision, the market will react before the central bank’s decision by incorporating this information (the upcoming rate cut) to price the exchange rate. Just as you would not buy a product if you expected its price to fall in the coming days, investors will not buy euros if they expect its value to fall against the dollar. This effectively leads to a decline in demand for euros and therefore to a price adjustment even before the central bank’s decision has been made. On the day of the decision, there will be no significant movement in the exchange rate, and it will be said that the market had already « priced in » the event.
Knowing whether or not the market anticipates a central bank decision (among other things) is important for interpreting market movements (particularly exchange rates). When the ECB decided to lower its key interest rate last June (June 5), the impact on the exchange rate was marginal, leading some to say that the measure had no impact. However, others countered that the market had already « priced it in, « which explains the lack of movement on the day of the decision. On the contrary, last September, the rate cut was clearly not anticipated by the markets (i.e., not priced in), and as a result, the reaction on the exchange rate occurred at the very moment the decision was announced.
J.P.
