What is Fair Value
Understanding how to
calculate fair value is essential to anyone that
undertakes to
trade
equity
futures.
The fair value measurement of an assets value is a relatively simple
calculation but
it is surprising how even
experienced traders can fail to understand
the whole concept of 'fair-value'
itself.
Why is there a difference
between the futures price of an asset and the markets
cash price? Some traders believe that this price differential simply
reflects the markets
sentiment and that all they have to do is buy one
and sell the other as a hedge, then sit back until the futures contract
expires
and reap the rewards. Wouldn't that be fantastic?
Unfortunately
there is no such thing as a free lunch in trading the stock market,
trading
equity futures is no different. If it were as simple as that the Stock
Exchanges would be very quiet places, all the traders would all be on
the
beach.
It
is true to say that the Futures and Cash prices will
always return to
parity but there is slightly more to it than simply trading
one
against the other. To find out if the futures really are trading at a
premium or a discount to the cash price you need to fully
understand Fair Value.
A futures contract is an agreement to buy or sell an asset at a
predefined point in the future at a price that is agreed today.
Fair Value is the theoretical
price at which the futures contract
should be trading at to reflect todays cash price and the cost of carry
Fair Value = Cash price + Cost of
Carry
How to Calculate Fair Value for
Commodities
The
cost of carry is a suppliers associated costs with fulfilling that
contract so these need to be taken in to account to calculate fair
value for commodities.
- Storage
costs
- Insurance
costs
- Loss of interest on funds that
could have been reinvested if the asset had been sold immediately
These costs vary between assets and also between contracts.
The
cost of storing and insuring Crude Oil for example, might be
substantially
higher than storing and insuring Lumber or Cotton and the
cost of storing Live Cattle can be substantially lower in the summer
months when they are put out to graze than it is in winter when they
may need to be kept indoors and fed.
How to Calculate Fair Value for
Financial Products
There
are no storage costs to pay If you were to purchase a futures contract
of a Financial Product such as the
Dow Jones Industrial Average stock
index (DJIA) but there are interest payment costs and
dividend payments
to take in to account when you calculate
fair value for financial
products.
Fair Value = Cash price +
Interest Costs - Dividend Payments
It is August and Wall Street cash is at 10221.....Decembers Futures
Contract is quoted at 10152....69 points lower!
The
interest costs are based on the Libor interest rate over the time to
run until expiry. To calculate the daily rate this done by using a
divisor of 360, in the UK it is 365.
The calculation for fair value measurement using the formula
above is
Fair Value = Cash + [Cash x Days
till Expiry / ( Libor / 360 ) ] - Dividends
If the Libor rate is 2.4% and there are 105 days to expiry the
interest payable over the 105 day period is 2.4 / 360 x 105 = 0.7%
Example
of how to calculate Fair Value
| DJIA
Futures
Price |
10152
|
| DJIA
Cash
Price |
10221 |
| Interest
Rate (Libor) |
2.4% |
| Days
until Expiry |
105 |
Dividends
Payable before Expiry
(Value of dividend payments in index points) |
142 |
| Interest
Payable over the 105 day period = 0.024 / 360 x 105 |
0.007 |
| Fair
Value = Cash + [Cash x Days till Expiry / ( Libor / 360 ) ] - Dividends |
|
| Fair
Value = 10221 + [ 10221 x 105 / ( 0.024 / 360 ) ] - 142 |
10150.55 |
| DJIA
Futures
vs Fair Value 10152 - 10150.55 |
+
1.45 |
As we can see in this example using the Dow Jones Industrial Average,
even though futures may be trading
at a lower level than the cash
price, it is possible that they may be priced at a premium
and if a
trader were to short cash and buy the futures in the search of that
guaranteed
69 point profit, they in fact be locking in a
guaranteed loss instead, in this case 1.45 points.
It is possible to make a
profit form that type of trade, it is called
Arbitrage Trading, but most traders and investors do not have
access to the extremely tight spreads or the spread of dealing that is
required to do it
successfully. Most of this type of trade is done by
computerized
trading systems.
|
