OpenMarkets Weekly: Understanding Fair Value

At a Glance

  • Fair value can be used as a basic indicator for measuring market sentiment.

The concept of fair value between futures and stocks is one of the least understood fundamentals of markets. It is reflected on every network TV business channel and gives traders and investors a good look at the prospects for the opening of the stock market. 

In the S&P 500 futures, fair value is the theoretical spread which should exist between the stock market and the futures market. Fair value can show the difference between the futures price and what it would cost to own all 500 stocks in the index. The fair value always refers to the front-month futures contract as opposed to the back-month’s contracts.

How To Calculate Fair Value

Fair value between the S&P 500 futures and the underlying cash market is calculated by the following variables: The current S&P cash value, the current interest rate paid to a broker to buy all 500 stocks in the S&P 500 index, the number of days to expiration of the futures contract and the total amount of dividends until contract expiration, expressed in terms of points on the S&P contract. This calculation changes daily but will converge at settlement.  That is, the futures price and the stock market price will be the same at the expiration of the futures contract.

Index arbitrage utilizes the price differences among identical or similar financial instruments on different markets or in different forms such as the S&P 500 futures and all 500 stocks trading in the index. When the spread between the futures and stocks widens, index arbitrageurs will keep the market in line by selling futures and buying stocks, this is also called a ‘buy program’. When the spread narrows, they will buy futures and sell stocks, known as a sell program.

Through index arbitrage, traders can profit from a price disparity by simultaneously buying and selling.  The role of the index arbitrageur is to keep the futures market in line with the cash market. They play a major role in creating a liquid, efficient central price discovery mechanism.

Since stocks settle 15 minutes prior to the futures settlement, there are times, such as dividend releases, which drive the spread out of line after stocks close. It is at these times that traders and investors get good insight into the next trading session.

Although the concept of fair value can appear overly complicated, the active trader can also use the spread as a basic indicator for market sentiment. Understanding how it is used can help every trader and investor.

 

H. Jack Bouroudjian is chairman of Bull & Bear Partners, a financial services holding company based in Chicago. He is the host of the syndicated program “The Jack B. Show”, a regular commentator on CNBC, author of “Secrets of the Trading Pros” (Wiley, 2007) and a columnist for Townhall Finance.

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