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Forgive me, Dejan, but I think you still misunderstand what "fair value" is,
or what its purpose is.
The S&P futures contract has a sort of equivalence to a basket of securities
equal to the S&P 500 index - that is, holding a long contract is somewhat
equivalent to holding the basket of securities. When the future is "cheap"
relative to the basket (i.e., relative to the cash index) then arbitrageurs
will buy the future and sell the basket. Conversely, when the future is
"expensive" relative to the basket, arbitrageurs will sell the future and
buy the basket.
They are not EXACTLY equivalent, however. If you are holding the basket,
you are receiving dividends which a holder of the future does NOT receive.
And if you are holding the future, you can be earning interest on the cash
you would otherwise have to pay out to purchase the basket. Finally, there
are transaction costs incurred in switching from future to basket or vice
versa.
"Fair value", therefore, represents the value of the premium (difference
between the future and the cash index) at which there is no profit in making
a switch; this value is a function of the expected S&P dividends over the
remaining life of the contract, the "risk-free" interest rate, and the
number of days remaining to contract expiration. Actually there is a zone
around this fair value within which there is no profit potential. The upper
and lower bounds of this zone are defined by the transaction costs to make
the switch. The future is "cheap", therefore, whenever its price drops
below the lower bound; it is "expensive" whenever its price rises above the
upper bound.
So the premium is not someone's attempt to approximate the fair value - it's
the very real difference between the contract price and the cash index.
Also, because the premium declines to zero as the contract expiration
approaches, I feel that the only valid indicator based on it is one which
compares the actual premium with the fair value.
One final point - it's not correct that fair value can be determined only at
the end of the day. I calculate it continuously during the day.
Regards,
Carroll Slemaker
----- Original Message -----
From: Dejan Corovic <Dejan.Corovic@xxxxxxxxxxxxxx>
To: Carroll Slemaker <cslemaker1@xxxxxxxx>
Sent: Friday, July 09, 1999 12:05 AM
Subject: RE: HyperFeed 2000 and S&P fair value ...
> Hi Carroll,
>
> Thank you for the reply. I am looking at DBC's symbol notation:
>
> $PREM - S&P 500 Futures Minus Cash Spr
>
> Yes, I think you are right. My understanding is that $PREM (or
> premium) is intraday realtime approximation for fair value what
> can only be calculated on the end of the day.
>
> I use $PREM to help me see whether SP500 is overbought/oversold.
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