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Fair value: mystery exposed
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May 2, 1999: 3:21 p.m. ET
Once the realm of MBAs, fair value becoming a must-know for investors
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NEW YORK (CNNfn) - "Fair value."
At arbitrage desks at investment banks around the world, the term is bantered about by traders looking for quick money.
But the phrase isn't just for MBAs any more.
Rather, the term "fair value" has trickled into the world of business journalism, where readers and viewers get its quotes alongside financial staples like the dollar, the 30-year bond and the price of light, sweet crude.
But what is fair value? And why does it matter?
Back to the futures
Understanding the term begins with comprehending the relationship between a futures contract -- in this case the S&P 500 futures contract -- and the underlying cash commodity that the contract's value is derived from, in this case the S&P 500 stock index.
The theoretical price of owning all 500 stocks in S&P 500 will always be different than the price of owning an S&P futures contract.
This difference comes from two factors.
First, if you bought all of the stocks in the S&P 500, you'd have to fully finance the purchase -- a huge undertaking -- or borrow from your broker at the prevailing short-term interest rate.
Those who calculate the fair-value figure -- big investment banks and brokerages -- factor in this constantly changing borrowing cost.
Second, if you owned the stocks in the index, you'd receive dividends. However, futures don't pay dividends.
So, adjusting for the fair value of an S&P 500 futures contract versus the underlying S&P 500 index requires adding the cost of borrowing, but subtracting the gain from dividends.
If fair value is "plus 10," for example, the futures contract needs to be 10 points above the cash index to be at fair value. (One point equals $250 on the contract).
Fair value in action
Calculating fair value can help experts predict which way the market is heading.
Consider a real-life example.
On Tuesday, April 27, the S&P 500 index closed at 1,362.80.
S&P futures closed higher, at 1,376.50. (This discrepancy often occurs because the Chicago Mercantile Exchange, where S&P futures trade, is open 15 minutes later than the New York Stock Exchange).
The day's futures close of 1,376.50, according to those who calculate the figure, was 6.7 points above fair value.
The next morning, 90 minutes before the opening bell, S&P futures -- which also trade during an overnight session -- were down 6 points from the previous day's close.
But when fair value of positive 6.7 is added, the contract's relationship to cash came in at 0.7 points on the plus side.
Knowing that the S&P 500 futures' fair value thus slightly led the S&P 500 index's close from the day before, market forecasters called for the stock market to open that Wednesday, April 28, flat to slightly higher.
Sure enough, just before 10 a.m. ET, the S&P 500 index was up a marginal 1.84 points at 1,364.64.
The arbitrageurs
There's another way fair value has relevance.
During the trading day, when the S&P index and the futures trade simultaneously, the S&P 500 futures contract usually moves in a fair-value relationship to the "live" S&P 500 index.
But occasionally, the S&P 500 futures contract may trade at premium or discount to the "live" S&P 500 index.
When this happens, people called arbitrage traders -- who look to take advantage of temporary price disparities in the market -- will buy or sell in order to make money when the S&P 500 futures contract returns to its historic relationship to the "live" S&P 500 index.
Here's an example:
If futures trade over their fair value to the index price, a trader would agree to sell the contract at a future date, believing its price will fall.
If this fall happens, the arbitrageur will profit by pocketing the difference between selling the higher-priced contract and buying the cheaper one.
-- by staff writer Jake Ulick
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