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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Video transcript
Voiceover: The fair value of a futures contract is the price of the contract at which a buyer of the stock would be neutral between buying it on in an actual stock exchange and actually buying the stock and agreeing to buy the futures contract. Or a seller of the stock would be neutral between selling it right now in the actual exchange versus agreeing to go short or agreeing to be on the selling side for a futures contract. The fair value attends to be quoted for the front month or the next expiring futures contract. Next expiring futures contract. To see how this works, why someone would be neutral between say, buying something now for a $100 and agreeing to buy it maybe next month at a $102, think of it this way. If they want to just hold that stock a month, or two, or three from now, they could pay a $100 right now or they could take their $100 so they could either just buy it right now or they could stick it maybe in the money market account. They could get some interest for the next few weeks and then they could buy the futures contract. If they got interest of $2, if they kept that $100 say in a money market account for the next, until the actual contract date for that futures contract they'd be neutral. I could spend a $100 today or I could put a $100 in a money market account, get $2 in interest and I'm not going to worry about the dividends right now. If a dividend happens then, obviously you would want to pay less for this thing where you didn't get the dividend. Assuming no dividends, you say well or I'd be willing to pay a $102 for that. If this was only a $101, if the price of the futures contract was a $101, then you say, "Wait, if the price of the futures contract is a $101," "I would rather put my money in a money market account, get $2 of interest." "And buy it in a month for a $101." I'll essentially get an extra dollar if I do that. If the price is at a $103, you say, "Well gee, if I want to hold that stock" "a month or two from now. I'm way better buying it right now." Or another way to think about it if the price is at a $103 and I'm a seller of the stock. Instead of selling it today for a $100, let's say I really need a $100 right now. I'm better off borrowing a $100 right now. Paying maybe $2 in interest and then selling it a month later for a $103. The fair value is the price which a buyer or seller is neutral between buying and selling the stock or entering into a futures contract. I'm going to go a little bit more detail in the next video but it's main use is an indicator of what's likely to happen once a market opens and that's because futures markets trade have much longer trading hours, sometimes 24 hours than traditional stock markets. If you could imagine, if the price of a futures contract is trading below its fair value, the only reason why that would happen is if a lot of people are actually expecting, once the market opens that the stock price is going to go down.