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>I hate to waste anyones time, but if someone would please help me
understand
> >"fair value" I would really appreciate it
A simpler way to think of fair value is this:
People who sell futures- especially commodity futures- must have the
physical (cash) object on hand, or obtain it.
The "fair value" of, say, a gold future, is looked on as the cost of the
physical gold PLUS the cost of keeping it, eg. storehouse expenses etc. For
grain futures, this might involve air conditioning, etc.
So the "fair value" is looked on as the physical price plus the cost to the
supplier of keeping it. Therefore, futures always in theory trade at a
premium to the "cash" or physical product.
For financial futures, eg. index futures or bond futures, the fair value is
looked at as what that amount of money would be worth if invested for
interest for a similar period of time.
Eg., you buy a March index future. The person who sells it to you is
obligated to keep a certain amount of money tied up to cover the future.
Instead they could have invested this money in the short term interest
market till March. So the "fair value" attached to the cost of the cash
index is the short term interest rate, to make the future an attractive
alternative.
Naturally, as the March deadline approaches, the 'fair value" begins to
decay. The more life the future has, the larger the fair value should be.
Of course, this is ideal. Reality is, the futures and cash price fluctuate
all the time, somtimes being inverse to each other. Since they will
re-stabilize, often people will sell one and buy the other, to lock in
profit (arbitrage). Someone else here (Bob Nelson) previously mentioned
this.
Of course, the real formula for fair value takes other things into
consideration, but simply imagining it as the cost of holding to the
supplier simplifies things.
Regards,
Wayne
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