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Current time:0:00Total duration:3:38

Video transcript

in the first video in futures fair value we learned that it was the price at which an investor would be neutral between buying the stock on the actual stock market or buying the front month futures contract what I want to do in this video is talk about how does one interpret the fair value especially relative to the futures price so let's say you wake up one morning the market hasn't opened yet the stock market hasn't opened and you see a quote like this for stock ABCD the fair value according to the closing of yesterday's trading the fair value is 102 dollars but the futures market which trades which trades usually has trading hours beyond the regular market and often times 24 hours so the futures market trading price for the front month future even though the fair value based on yesterday's closing is 102 the futures market is trading it at 101 dollars so how would you use that information or how would one interpret that information so in the futures market people are trading the futures contract they're they're buying and selling at a price below the fair value based on yesterday's close price so what that means is is that the market thinks that this is actually no longer the correct price of the stock they think that the correct price of the stock is the stock at which they would be neutral between that price and this futures contract so I don't know what it is you would have to discount it back by the risk-free rate but maybe it's something like so this is implicitly saying that the correct price of the stock isn't $100 if the futures price was 102 dollars it would say that the stock should be a hundred if the futures price is 101 dollars it means that maybe the stock is something less than that maybe if we do our math maybe it implies maybe it implies a stock price of 90 maybe it implies a stock price of $99 of 99 dollars so the way you would potentially act on it although it's it's easier said than done is say well look that means that at least in the very early stages once the market opens the stock is going to go down now your initial reaction might be saying wow this is really amazing this is some type of a future indicator and it is a pretty strong future indicator when you see this when you see the actual price of the future being below the fair value it is very likely that the stock we'll open down unfortunately you have many many very sophisticated high-frequency traders who already have their computers set up to look at this type of a discrepancy and they're going to be ultra fast and they're optimizing how fast their bandwidth is so that they can do these in a matter of split second so it's very very very unlikely that a that a an average investor or even a reasonably sophisticated investor will be able to take advantage of this type of an arbitrage or this type of an expected arbitrage to know that this price is likely to go down now if the opposite happened and let's say that the fair value is 102 dollars which implies the fair value of the front much front month futures contract is 102 dollars which implies $100 stock price let's say that the that the futures is actually trading even though the even though the fair value is 102 dollars let's say that it is trading at let's say that it is trading at 105 dollars so this is a situation that since the market closed the futures market for some reason thinks that the stock is going to be worth more this would imply a stock price of maybe I don't know what it might be I'm not going to do the math exactly but maybe a price of 103 or 104 dollars and so if you saw this where the futures price is above the fair value in the pre-market that means that the stock is likely to go up but once again it's very hard to take advantage of because you're gonna see that movement very very very quickly