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# Fair Value

I need a lesson on fair value. I would like to be able to know what the difference is between the $INDU and @YM pricing, how to calculate fair value, and what the difference in price means to the trader. Thanks.

Refer to the spreadsheet attached for the calculations that I did.

What I think will be a good exercise is if we revisit this topic again in 30 and 60 days time and see how the values have changed over this time period.

First off I'm doing this from memory and it's been about 10 years since I wrote exams in this but I believe that this is correct.

What I did to determine a good price to use was to quickly scan today's action and find a period of the day when the market wasn't moving around too much and found that the movement over the 1 minute interval at 14:38 EST was very small. I used the high and low of the YM and the DJIA to get an average value over this 1 minute for the comparison.

The spreadsheet shows that the YM is priced 79.53 points above the DJIA and that there are 85 days to expiration.

Now the reason for this premium is because you can control $58,000 worth of the DJIA index and only pony up $1,000 (margin) to do so. The premium is the cost-of-carry. i.e. what it will cost you in interest payments to borrow the $58,000 and directly invest in the constituent stocks that make up the DJIA.

The YM is currently 80 points above the DJIA price and at $5 per contract that's around $400 over. If you take that as a percentage of what you are controlling and annualize it you come out with about 3%. This 3% is what it cost the institutions to borrow the money to buy the DJIA constituents. You can also look at it another way and say this is what they could be earning from their money if they didn't have it invested in the DJIA.

So to come back to your question about fair value it depends on what you can borrow money for. Using the rate at which you can borrow money you can reverse the calculation in the spreadsheet and come out with a fair value for the YM.

Say you can borrow money at 2%. In that case the YM, for you, is priced above its fair value. If you can borrow at 4% then the YM is priced below its fair value.

What I think will be a good exercise is if we revisit this topic again in 30 and 60 days time and see how the values have changed over this time period.

First off I'm doing this from memory and it's been about 10 years since I wrote exams in this but I believe that this is correct.

What I did to determine a good price to use was to quickly scan today's action and find a period of the day when the market wasn't moving around too much and found that the movement over the 1 minute interval at 14:38 EST was very small. I used the high and low of the YM and the DJIA to get an average value over this 1 minute for the comparison.

The spreadsheet shows that the YM is priced 79.53 points above the DJIA and that there are 85 days to expiration.

Now the reason for this premium is because you can control $58,000 worth of the DJIA index and only pony up $1,000 (margin) to do so. The premium is the cost-of-carry. i.e. what it will cost you in interest payments to borrow the $58,000 and directly invest in the constituent stocks that make up the DJIA.

The YM is currently 80 points above the DJIA price and at $5 per contract that's around $400 over. If you take that as a percentage of what you are controlling and annualize it you come out with about 3%. This 3% is what it cost the institutions to borrow the money to buy the DJIA constituents. You can also look at it another way and say this is what they could be earning from their money if they didn't have it invested in the DJIA.

So to come back to your question about fair value it depends on what you can borrow money for. Using the rate at which you can borrow money you can reverse the calculation in the spreadsheet and come out with a fair value for the YM.

Say you can borrow money at 2%. In that case the YM, for you, is priced above its fair value. If you can borrow at 4% then the YM is priced below its fair value.

Click link to access uploaded file:

FairValue.xls

FairValue.xls

Thanks. I'll let it soak in and see what I come up with. I appreciate it.

You're welcome. In a nutshell you can look at the premium and the interest rates as opposite sides of the same equation. Given the premium you can calculate the implied interest rate. Given the interest rate you can calculate the fair value.

**Fair value**I'm quoting from Investopedia

What does it mean?

In the futures market, fair value is the equilibrium price for a futures contract. This is equal to the spot price after taking into account compounded interest (and dividends lost because the investor owns the futures contract rather than the physical stocks) over a certain period of time.

Investopedia says?

The "fair value" quoted on TV refers to the relationship between the futures contract on a market index and the actual value of the index. If the futures are above fair value then traders are betting the market index will go higher, the opposite is true if futures are below fair value.

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Copyright © 2004-2016, MyPivots. All rights reserved.