Understanding Futures Fair Value: A Beginner's Guide - Trading-Lab

Alchemist · #1 06-18-2007, 02:29 PM

The following excerpts are taken from:

http://www.cme.com/trading/prd/equity/fairvalue.html
http://www.cme.com/trading/prd/equity/fairvaluefaq.html

FAIR VALUE

Fair value is the theoretical assumption of where a futures contract should be priced given such things as the current index level, index dividends, days to expiration and interest rates. The actual futures price will not necessarily trade at the theoretical price, as short-term supply and demand will cause price to fluctuate around fair value. Price discrepancies above or below fair value should cause arbitrageurs to return the market closer to its fair value.

The following formula is used to calculate fair value for stock index futures:

= cash [1+r (x/360)] - Dividends

This example shows how to calculate fair value for S&P 500® futures:

Sept S&P 500 futures price

1157.00 pts

S&P 500 cash index

1146.00 pts

Interest rate

5.7%

Dividends to expiration of futures

3.47 pts

(converted to S&P points)

Days to expiration of Dec. futures

78 days

Fair Value of futures =

Cash [1+r (x/360)] - Dividends

= 1146 [1+.057 (78/360)] - 3.47

1156.68

Amount of futures overpricing =

1157.00 - 1156.68

.32 pts

Dividend Yield Calculation

S&P 500 dividend yield =

1.40%

Conversion to S&P points =

1146.00 x .0140

= 16 pts per year (78/360)

FAIR VALUE FAQs

Q1
How are settlement prices determined on the last business day of each month?
A1
Settlement prices for domestic stock index futures and options are determined on the basis of their fair value, i.e., by reference to the closing cash index value plus finance charges less anticipated dividends. Because the final cash index value may not be known for several minutes past the cash close, the cash index component of the calculation will be surveyed at 3:15 p.m. (Chicago time) and settlements will be made available shortly thereafter. As is the practice with other Exchange products, fair values will be determined through a survey of market participants.
That survey will be conducted by Exchange staff. Settlement prices will be made available shortly after sampling the 3:15 p.m. (Chicago time) cash index values. CME® stock index futures and options will close at 3:15 p.m. (Chicago time) on the last business day of each month when FV settlement procedures are employed. This is fifteen (15) minutes past the normal cash equity market close at 3:00 p.m. (Chicago time).
Regular settlement procedures will be observed on all other trading days apart from the last business day of each month.

Q2
How will settlements be determined if the cash index value is unavailable at 3:15 p.m. (Chicago time)?
A2
In the event that the cash value of any index affected by these procedures is unavailable at 3:15 p.m. (Chicago time), due to a mechanical failure of quotation services, settlement values will be determined as follows...

The cash index value sampled for use as the basis of the fair value calculation shall be based upon the next available live quotation of the index prior to 3:20 p.m. (Chicago time).
If a live cash index value does not become available prior to 3:20 p.m. (Chicago time), the cash index value sampled for use at the basis of the fair value calculation shall be based on the most recent live quotation that was posted subsequent to 3:00 p.m. (Chicago) time.
If a live cash index value was not posted subsequent to 3:00 p.m. (Chicago time), then regular settlement procedures shall be applied to the market so affected.

Q3
What products are affected by this procedure?
A3
All domestic stock index futures and options are affected by this procedure. That includes the S&P 500®, E-mini TM S&P 500, NASDAQ-100®, E-mini NASDAQ-100, S&P/Citigroup 500 Growth Index, S&P 500 /Citigroup Value Index, the S&P MidCap 400 TM , the Russell 2000®, E-mini Russell 2000 and FORTUNE e-50® markets. While the Nikkei® 225 will not be settled with use of this procedure, it will nonetheless be closed at 3:15 p.m. (Chicago time) in sync with other stock index markets on the last day of the month.

Q4
What is meant by the term "fair value"?
A4
Fair value represents the level at which futures theoretically should be priced in relation to cash index values in the absence of transaction costs – albeit not where they necessarily will trade. It represents a value at which arbitrageurs should find no opportunity in buying or selling the cash/futures basis. It is typically calculated as a function of the cash or spot index value plus financing charges (often determined as a function of 3-month LIBOR rates) less any dividends that would accrue with the purchase and carry of all index constituents until the final futures settlement date.

Q5
Why has this procedure been implemented?
A5
Stock index products on the Exchange normally close and settle fifteen minutes after the daily close of trading in cash equities. The cash/futures basis may be affected to the extent that futures may fluctuate – sometimes sharply – during those final fifteen minutes. As such, this may become a difficulty for institutional traders practicing coordinated cash/futures strategies. Still, the opportunity to lay off equity market exposure during those fifteen minutes subsequent to the cash close has proven quite beneficial.
The use of FV settlement procedures is intended to address this so-called "tracking error" – while still permitting trade to continue for fifteen minutes past the 3:00 p.m. cash close.

Q6
What are the trading hours on days when FV settlement procedures are applied?
A6
Consistent with normal practices, Regular Trading Hours (RTH) for stock index futures and options shall be conducted from 8:30 a.m. to 3:15 p.m. (Chicago time) on the last day of each month – unless notified otherwise because of a holiday. As such, this procedure will permit trading to continue for fifteen minutes past the normal 3:00 p.m. (Chicago time) cash close while ensuring that settlements will be tied to cash values. This will be followed, after a brief delay, by a three-minute post-settlement session.

Q7
How will options be settled on days when FV settlement procedures are applied?
A7
Options on futures settlement values shall be established on the basis of the adjusted fair value futures settlements on days when FV settlement procedures are employed. This is conceptually similar to the procedures normally used to identify daily settlement prices for away-from-the-money options or options which simply did not trade near the close.

Q8
How will Market-on-Close (MOC) orders be handled on days when FV settlement procedures are applied?
A8
Market-on-Close (MOC) orders shall be handled in the typical fashion on days when FV settlement procedures are applied. In other words, an MOC order becomes a market order to be filled at prevailing prices during the last thirty seconds of the trading session, i.e., between 3:14:30 and 3:15:00. The filled price may or may not resemble the settlement price.

Q9
How will the post-close session be conducted on days when FV settlement procedures are applied?
A9
Trading shall be permitted during the post-close session on days when FV settlement procedures are applied at prices within the 3:14:30-3:15:00 closing range – per normal practices. Note that these prices may depart from the fair-value settlement price.

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#1 06-18-2007, 02:29 PM
Alchemist founder of Trading-Lab Join Date: May 2007 Location: New York, NY Posts: 296	Understanding Futures Fair Value: A Beginner's Guide The following excerpts are taken from: http://www.cme.com/trading/prd/equity/fairvalue.html http://www.cme.com/trading/prd/equity/fairvaluefaq.html FAIR VALUE Fair value is the theoretical assumption of where a futures contract should be priced given such things as the current index level, index dividends, days to expiration and interest rates. The actual futures price will not necessarily trade at the theoretical price, as short-term supply and demand will cause price to fluctuate around fair value. Price discrepancies above or below fair value should cause arbitrageurs to return the market closer to its fair value. The following formula is used to calculate fair value for stock index futures: = cash [1+r (x/360)] - Dividends This example shows how to calculate fair value for S&P 500® futures: Sept S&P 500 futures price 1157.00 pts S&P 500 cash index 1146.00 pts Interest rate 5.7% Dividends to expiration of futures 3.47 pts (converted to S&P points) Days to expiration of Dec. futures 78 days Fair Value of futures = Cash [1+r (x/360)] - Dividends = 1146 [1+.057 (78/360)] - 3.47 1156.68 Amount of futures overpricing = 1157.00 - 1156.68 .32 pts Dividend Yield Calculation S&P 500 dividend yield = 1.40% Conversion to S&P points = 1146.00 x .0140 = 16 pts per year (78/360) FAIR VALUE FAQs Q1 How are settlement prices determined on the last business day of each month? A1 Settlement prices for domestic stock index futures and options are determined on the basis of their fair value, i.e., by reference to the closing cash index value plus finance charges less anticipated dividends. Because the final cash index value may not be known for several minutes past the cash close, the cash index component of the calculation will be surveyed at 3:15 p.m. (Chicago time) and settlements will be made available shortly thereafter. As is the practice with other Exchange products, fair values will be determined through a survey of market participants. That survey will be conducted by Exchange staff. Settlement prices will be made available shortly after sampling the 3:15 p.m. (Chicago time) cash index values. CME® stock index futures and options will close at 3:15 p.m. (Chicago time) on the last business day of each month when FV settlement procedures are employed. This is fifteen (15) minutes past the normal cash equity market close at 3:00 p.m. (Chicago time). Regular settlement procedures will be observed on all other trading days apart from the last business day of each month. Q2 How will settlements be determined if the cash index value is unavailable at 3:15 p.m. (Chicago time)? A2 In the event that the cash value of any index affected by these procedures is unavailable at 3:15 p.m. (Chicago time), due to a mechanical failure of quotation services, settlement values will be determined as follows... The cash index value sampled for use as the basis of the fair value calculation shall be based upon the next available live quotation of the index prior to 3:20 p.m. (Chicago time). If a live cash index value does not become available prior to 3:20 p.m. (Chicago time), the cash index value sampled for use at the basis of the fair value calculation shall be based on the most recent live quotation that was posted subsequent to 3:00 p.m. (Chicago) time. If a live cash index value was not posted subsequent to 3:00 p.m. (Chicago time), then regular settlement procedures shall be applied to the market so affected. Q3 What products are affected by this procedure? A3 All domestic stock index futures and options are affected by this procedure. That includes the S&P 500®, E-mini TM S&P 500, NASDAQ-100®, E-mini NASDAQ-100, S&P/Citigroup 500 Growth Index, S&P 500 /Citigroup Value Index, the S&P MidCap 400 TM , the Russell 2000®, E-mini Russell 2000 and FORTUNE e-50® markets. While the Nikkei® 225 will not be settled with use of this procedure, it will nonetheless be closed at 3:15 p.m. (Chicago time) in sync with other stock index markets on the last day of the month. Q4 What is meant by the term "fair value"? A4 Fair value represents the level at which futures theoretically should be priced in relation to cash index values in the absence of transaction costs – albeit not where they necessarily will trade. It represents a value at which arbitrageurs should find no opportunity in buying or selling the cash/futures basis. It is typically calculated as a function of the cash or spot index value plus financing charges (often determined as a function of 3-month LIBOR rates) less any dividends that would accrue with the purchase and carry of all index constituents until the final futures settlement date. Q5 Why has this procedure been implemented? A5 Stock index products on the Exchange normally close and settle fifteen minutes after the daily close of trading in cash equities. The cash/futures basis may be affected to the extent that futures may fluctuate – sometimes sharply – during those final fifteen minutes. As such, this may become a difficulty for institutional traders practicing coordinated cash/futures strategies. Still, the opportunity to lay off equity market exposure during those fifteen minutes subsequent to the cash close has proven quite beneficial. The use of FV settlement procedures is intended to address this so-called "tracking error" – while still permitting trade to continue for fifteen minutes past the 3:00 p.m. cash close. Q6 What are the trading hours on days when FV settlement procedures are applied? A6 Consistent with normal practices, Regular Trading Hours (RTH) for stock index futures and options shall be conducted from 8:30 a.m. to 3:15 p.m. (Chicago time) on the last day of each month – unless notified otherwise because of a holiday. As such, this procedure will permit trading to continue for fifteen minutes past the normal 3:00 p.m. (Chicago time) cash close while ensuring that settlements will be tied to cash values. This will be followed, after a brief delay, by a three-minute post-settlement session. Q7 How will options be settled on days when FV settlement procedures are applied? A7 Options on futures settlement values shall be established on the basis of the adjusted fair value futures settlements on days when FV settlement procedures are employed. This is conceptually similar to the procedures normally used to identify daily settlement prices for away-from-the-money options or options which simply did not trade near the close. Q8 How will Market-on-Close (MOC) orders be handled on days when FV settlement procedures are applied? A8 Market-on-Close (MOC) orders shall be handled in the typical fashion on days when FV settlement procedures are applied. In other words, an MOC order becomes a market order to be filled at prevailing prices during the last thirty seconds of the trading session, i.e., between 3:14:30 and 3:15:00. The filled price may or may not resemble the settlement price. Q9 How will the post-close session be conducted on days when FV settlement procedures are applied? A9 Trading shall be permitted during the post-close session on days when FV settlement procedures are applied at prices within the 3:14:30-3:15:00 closing range – per normal practices. Note that these prices may depart from the fair-value settlement price.