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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
In the first video on 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, but the futures market, which 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. 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 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, it would say that the stock should be 100. If the futures prices is $101, it means that maybe the stock is something less than that. Maybe if we do our math maybe it implies a stock price of $99. So the way you would potentially act on it, although 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 will 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 seconds. So it's very, very, very unlikely that 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, which implies the fair value of the front month futures contract is $102, which implies $100 stock price. Let's say that the futures is actually trading even though the fair value is $102, let's say that it is trading at $105. 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. 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 going to see that movement very, very, very quickly.