Difference Between Futures and Fair value

Futures vs Fair value

Futures is a term that refers to contracts that specify a future date for delivery of tangible or intangible products at a price that is determined by the market. Tangible products can be any consumer goods like edibles, corn or machinery while intangible goods can be any financial instrument like stock options or indexes. They are normally used as insurance against price unpredictability and any changes that may arise due to speculation. They run quarterly and typically they are quoted referring to the ‘next expiration’ of the futures contract. Futures contracts that are based on stock market indices are known as index futures and the most common one is the S&P500. However it is worth knowing that the actual S&P500 and the futures S&P 500 do not mean the same thing.

The Future Value depends on the length of time to the ‘future’ date and on the ‘assumed’ amount of returns. The ‘intrinsic’ value of an option is the same as the difference between Present Value (current cash) and Future Value. Fair Value then is the ‘suitable’ association between the actual S&P500 (cash) and the S&P500 Futures. This relationship can be represented in a kind of complex formula. Most importantly, it should be remembered that there is no relationship between the Fair Value and the index, company or stock market values. The Spread is the value of the difference between the current S&P500 value and the futures contracts value. If the value of the difference is positive then it is called a ‘premium’ and if it’s negative it is called a ‘discount’. On a single day, the Spread will fluctuate as trading for the futures contract value and the S&P500 actual value is not influenced by either value. One important point to note is that when the Spread is at Fair Value, then owning the S&P futures instead of the S&P500 stocks doesn’t make it favorable. Generally speaking, a flurry of buying activities through computerized trading is triggered once the Spread (premium) is greater than the Fair Value because stocks will be better than the futures. On the other hand, selling activity will be spurred once the Spread is less than the Fair value. Computerized trading programs are automated so the difference between Spread and Fair Value disappears within a short time so the triggering factor for buying or selling goes away in a short time.

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