|
PureBytes Links
Trading Reference Links
|
That is a good explanation Carroll. The Wildcard is that each institution
doing the arbitrage will have a different internal cost of funds and
therefore a different "fair value" figure.
So on any given day you can get a lot of different "fair value" figures from
different sources.
Then again, any of them should be in the ball park. Especially when you
consider that each institution will have a different transaction cost
structure as well so their buy and sell parameters will vary from one trader
to the next.
Kevin
>Date: Fri, 9 Jul 1999 16:28:04 -0700
>From: "Carroll Slemaker" <cslemaker1@xxxxxxxx>
>
>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.
Without giving this much thought, what is the variable during the day? I
thought interest payments were made at the close of the day.
>
>Regards,
>Carroll Slemaker
|