Fair value

[Stevegclarke]

Hi all,
could anybody please explain to me what 'fair value' means and it can be used as a indicater? I have seen it on cnn pre market. Thankyou.

 

[fifty2aces]

And no, not really an indicator, it's just a number that is derived by looking at interest rates, dividend picture for the index constituent stocks, and possibly one or two other factors that I can't remember off the top of my head.

My understanding is that this is correct, and the significance of it is that stat arb traders will buy/sell futures/indices as the price deviates from fair value, as they expect the futures to return to fair value in the long term.

Example: if the futures end up trading well above fair value, program trades will kick in and start either selling futures, buying a basket of stocks, both, or something else, to bring prices back in line.

The problem with trying to use fair value is that there's no way of knowing that the futures will move in the expected direction - they might continue moving up, but the index moves faster and catches up. Also, the classic "markets can remain irrational longer than you can remain solvent", picking up pennies in front of a steamroller etc.

 

[Rhody Trader]

There is actually a simpler explanation for what CNN, CNBC, et al are showing.

The stock market closes at 4pm in NYC, but the futures don't close until 4:15. In that time, obviously, prices can change, especially with after hours earnings releases. As a result futures can get out of line with the cash in terms of their closes for the day. Of course in the pre-open the quotes shown for the change in the futures contract is from the previous day's close. Since the futures and cash closed at different times and therefore potentially at different prices, the change we see for the futures in the morning cannot necessarily be directly applied to the cash close to figure out where the index will be at. The news programs do their little fair value thing to help you see the real implication of where futures are trading now in terms of what that means for the cash.

Hopefully that makes sense.

 

[DT]

If you're looking at using it as an indicator in the very short term then you might find that quite a few people have thought of that.

I had a go at using the cash components as an indicator when I was starting out. Tis an interesting to investigate though I think plenty of other people have had the same idea in the past.

Got the weightings of the components (for some indicies like the FTSE you need the divisor and they are rather elusive regarding how it is calculated) and calculated the index in real time (most cash indexes aren't updated in real time but every say 10 seconds or so) then added on the fair value (you might need to do a bit of tweaking with this).

Depending on how comfortable you are with coding you could do all this with a fairly simple app or you could simply feed the data into excel. My basic premis was that for the most part the futures price ought to be pretty much the same as the calculated 'fair value price' but a large move in one of the major constituents of the index would be picked up before the official cash index updated and therefore you could scalp the futures based on seeing it early. The problem is that this is making quite a few assumptions about the behavior of the futures and I don't think there is too much of an edge here (or at least there are certainly better edges out there).

If you wanted to trade/arb cash components of an index vs the futures you're basically up against a lot of competition. There are software vendors specialising in spreading programs who'll claim that you can do this with their systems (i.e dax vs it constituents) and perhaps you may well find you can do this (would also be interesting to investigate biasing the weightings a bit towards certain stocks so not a complete arb more a spread trade with a market view of sorts).

Alternatives involve getting into the realms of black box trading and the complexity steps up quite a bit.... execution, exchange protocols/APIs, FIX protocol, code efficiency, networking issues etc...etc...

 

[DT]

My understanding is that this is correct, and the significance of it is that stat arb traders will buy/sell futures/indices as the price deviates from fair value, as they expect the futures to return to fair value in the long term.

thats not stat arbitrage its just plain arbitrage

Stat arbitrage is a bit of a misnomer as it relies on a perceived historical correlation between two or more instruments - the correlation won't necessarily hold in the future.

In an arb between an index and its components the products are directly related and its pretty much just execution risk you need to worry about.

 

[fifty2aces]

thats not stat arbitrage its just plain arbitrage

Stat arbitrage is a bit of a misnomer as it relies on a perceived historical correlation between two or more instruments - the correlation won't necessarily hold in the future.

In an arb between an index and its components the products are directly related and its pretty much just execution risk you need to worry about.

We're not talking about an index and it's components, we're talking about an index and index futures. To be genuine arbitrage, there needs to be a risk-free profit, and since the spread between index values and futures prices can vary, there is a risk.

Definitions stolen from Wikipedia:

When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit

In statistical arbitrage there is a statistical mispricing of one or more assets based on the expected value of these assets.

 

[DT]

We're not talking about an index and it's components, we're talking about an index and index futures.

I think you're slightly confused - an index isn't a product rather a weighted measure of its components - if you want to trade the index then you can do so via its components - trading the cash vs the future is straight forward arbitrage. If you short the future above fair value and go long the constituents then you've already locked in a profit.

To be genuine arbitrage, there needs to be a risk-free profi

no there is execution risk - markets are very efficient and opportunities for this sort of arbitrage generally happens over short time frame