Subject: Derivatives - Futures and Fair Value

Last-Revised: 11 Apr 2000
Contributed-By: Chris Lott (contact me)

In the case of futures on equity indexes such as the S&P 500 contract, it is possible to make a careful computation of how much a futures contract should cost (in theory) based on the current market prices of the stocks in the index, current interest rates, how long until the contract expires, etc. This computation yields a theoretical result that is called the fair value of the contract. If the contract trades at prices that are far from the fair value, you can be fairly certain that traders will buy or sell contracts appropriately to exploit the differentce (also called arbitrage). Much of this trading is initiated by program traders; it gets restricted (curbed) when the markets have risen or fallen far during the course of a day.

Here are some resources about fair value of equity index futures.

• These articles from the Chicago Mercantile Exchange discuss calculating fair value and month-end fair value procedures.
  http://www.cme.com/trading/prd/equity/fairvalue2543.html, http://www.cme.com/trading/prd/equity/fairvaluefaq2544.html
• A few words from one of the program traders.
  http://www.programtrading.com/fvalue.htm