What Is Fair Value?

\Fair Value\, what is it and why it\'s important every morning. I\'m not surprised that folks don\'t know just what it is, because it\'s really not that easy to explain, let alone to understand! But let me give you the \highs and lows\ so you have an idea of what\'s going on.

\Fair value\ refers to the \proper\ relationship between the futures and the cash. What is the \cash?\ It\'s the S&P 500 index. Through a complex formula using current short term interest rates and the amount of time left until the futures contract expires, one can determine what the spread between the futures and the cash \should\ be.

When the spread is at fair value, where it \should\ be, there is no theoretical advantage to owning the futures instead of the cash, or vice versa. To professional investors and the big institutions, when the spread is at fair value, it makes no economic difference to them whether they own the futures or the actual stocks that make up the S&P 500. Their buy and sell decisions will be driven by other factors. But when the spread drops below fair value or moves above it by a large enough margin, then one of the choices (stocks or futures) will become more attractive than the other, and they will sell one and buy the other.

In really loose general terms, if the futures are well above fair value, they will dump those futures and buy the underlying stocks, thus closing the spread and causing an \up\ market. On the other hand if the futures are well below the fair value, they will sell the stocks, take the money and buy the futures. This is why the stocks \generally\ follow the futures action.

So, in the morning we find it quite useful to watch the futures versus the fair value. For instance, one day the futures were below fair value and sure enough we opened with the DOW off about 35 and the NASDAQ down 5. So the indicator worked that day. Some days it won\'t work that well and sometimes the futures suggest a major dumping and yet we get minimal selling. Don\'t forget that along with the futures versus fair value, we also have to be cognizant of global events, news will often move the market more than anything else.

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