What Is Fair Value
Fair value is the sale price agreed upon by a willing buyer and seller. The fair value of a stock is determined by the market where the stock is traded. Fair value also represents the value of a company’s assets and liabilities when a subsidiary company’s financial statements are consolidated with a parent company.
Specifically, the fair value is the theoretical calculation of how a futures stock index contract should be valued considering the current index value, dividends paid on stocks in the index, days to expiration of the futures contract, and current interest rates.
Understanding Fair Value
Fair value can show the difference between the futures price and what it would cost to own all stocks in that index.
For example, the formula for the fair value on the S&P futures contract is:
FairValue=Cash×{1+r(x/360)}−Dividendswhere:Cash=CurrentS&PCashValuer=CurrentinterestratepaidtoabrokertobuyallstocksintheS&P500indexx=DaystoexpirationofthefuturescontractDividends=AmountofdividendsuntilcontractexpirationexpressedintermsofpointsontheS&Pcontract
Fair Value VersusFutures Price
This value is often shown on financial news networks and displayed online before the equity markets open for trading. The fair value can provide a glimpse of overall market sentiment. The futures price may be different from the fair value due to the short-term influences of supply and demand for the futures contract. The fair value always refers to the front-month futures contract as opposed to a further out month contract.
This difference between the fair value result and the current S&P 500 futures price may represent an arbitrage opportunity for those assuming that the futures price will eventually revert back to the fair value price. Through arbitrage, a trader can profit from a price imbalance by simultaneously purchasing and selling an asset. The trade exploits the price differences among identical or similar financial instruments on different markets or in different forms.
The fair value and futures price will fluctuate during the course of the trading day. Futures contracts trade on the Chicago Mercantile Exchange while individual stocks as components of the S&P 500 are trading at dispersed stock exchanges around the country. Therefore, there are often discrepancies between the two.
FAQs
In the futures market, fair value is the equilibrium price for a futures contract or the point where the supply of goods matches demand. This is equal to the spot price and accounts for compounded interest and lost dividends resulting from the futures contract ownership versus a physical stock purchase.
What is the formula for fair value method? ›
Fair Value = Cash - Dividends
Here, cash denotes the current value of the security, r is the prevailing interest rate charged by the broker, x is the number of days left in the contract, and dividends refer to the number of dividends that the investor will receive before the expiration date.
How do you calculate market fair value? ›
Determining fair value
The Peter Lynch fair value calculation assumes that when a stock is fairly valued, the trailing P/E ratio of the stock (Price/EPS) will equal its long-term EPS growth rate: Fair Value = EPS * EPS Growth Rate.
How do you calculate the value of a futures market? ›
The futures value is the current futures price multiplied by the contract size.
What is the formula for futures value? ›
The formula for computing futures prices can be expressed as: Futures Prices = Spot Price * [1 + (RF * (X/365) - D)], where: The risk-free return rate, RF, signifies the rate one can earn throughout the year in a perfect market.
What is the formula for the fair value of a contract? ›
Fair value formula = Cash [1 + r (x/360)] – Dividends
r is the current interest rate that the broker charges. x is the remaining days in the futures contract.
What is the fair value rule? ›
» securities for which market quotations are readily available must be priced at. market value; and. » all other securities must be assigned a “fair value as determined in good faith by the board of directors” of the fund.
What is the difference between market value and fair market value? ›
Fair market value is intentionally distinct from similar terms, such as market value or appraised value, because it considers the economic principles of free and open market activity. In contrast, the term market value refers to the price of an asset in the marketplace.
What is the best evidence of fair value? ›
Quoted market prices in an active market are the best evidence of fair value and should be used, where they exist, to measure the financial instrument.
How does Warren Buffett calculate fair value? ›
Warren Buffet Fair Value Calculator. Warren Buffett calculates a stock's fair value based on the future cash flows it will generate, minus an appropriate risk premium.
The fair market value of property can be determined by several methods. A popular method is that the fair value can be set at the highest bid when selling the asset. Essentially, as long as you get the value you determined to be the fair price or more, it can be termed as the FMV of property.
What is the fair market value rule? ›
Fair market value is the price a business, property or other asset would sell for in an open and competitive market where the buyer and seller have adequate information of relevant facts, a reasonable time to complete a deal, are under no compulsion, are acting in their own interests and mutually agree on the price.
What is fair value in futures market? ›
Fair value is the theoretical assumption of where a futures contract should be priced given such things as the current index level, index dividends, days to expiration and interest rates.
How do you calculate future market value? ›
For example, assume we have $1,000 today and we invest it at 5% for one year. In one year, we will have $1,050.00. In this simple example, the future value is calculated as the present value*(1+the interest rate), or 1000*(1.05). If we made the same investment for two years, the future value would be $1,102.50.
What is futures fair value pricing? ›
Specifically, the fair value is the theoretical calculation of how a futures stock index contract should be valued considering the current index value, dividends paid on stocks in the index, days to expiration of the futures contract, and current interest rates.
What is the fair value of a futures bond? ›
Fair value is the theoretical assumption of where a futures contract should be priced given such things as the current index level, index dividends, days to expiration and interest rates.
How to calculate the fair value of a forward contract? ›
The key forward commitment valuation equations are:
- LongForward:Vt=PV[Ft−F0]=[Ft−(1+
- ShortForward:−Vt=PV[F0−Ft]=[F0−Ft](1+r)T−t Short Forward: − V t = PV [ F 0 − F t ] = [ F 0 − F t ] ( 1 + r ) T − t ,
- LongForward:Vt=St−PV[F0]=St.
- ShortForward:−Vt=PV[F0]−St=(1.
What determines the value of a futures contract? ›
A future contract's notional value is it's contract size multiplied by it's current price. It indicates the value of the underlying asset based on quantity and how much it is trading for, which helps you make decisions about a position and trade.
What is the difference between futures value and fair value? ›
Fair Value Versus Futures Price
The futures price may be different from the fair value due to the short-term influences of supply and demand for the futures contract. The fair value always refers to the front-month futures contract as opposed to a further out month contract.