Many financial sites and news outlets publish market futures and fair-value figures before the markets open every morning. These pre-market indicators predict the behavior of the markets in the future, but in different ways. Pre-market futures give investors a projection of the likelihood that the market will rise or fall over the next few sessions, while the fair-value indicator adjusts these pre-market futures by the actual value of shares purchased at opening. Knowing exactly how the two financial indicators are calculated and what they mean helps you make informed investment decisions based on the direction the markets are expected to take.
The onset of trading immediately prompts the futures value to change and gradually takes the element of prediction from fair value.
Exploring the Basics of Futures
Investors trading market futures place bets on the value of indexes such as the Standard & Poor's 500 stock index. Futures are traded on the Chicago Mercantile Exchange and predict what level the market will have on the futures expiry dates in March, June, September and December.
Futures represent the opinions of all the investors who invest in them about the level of the market when the futures expire. When futures are quoted in a pre-market context, they give an indication of whether investors expect the market to rise or fall in the near term.
Setting a Fair Value for Futures
While futures indicate where the market will go over the next few sessions, fair value is the futures rate before market opening adjusted for purchasing shares at the opening. It is the cost of buying shares based on the value of the stock market futures that expire at the next expiry date. When futures are higher than fair market, investors are expecting the market to rise, while if they are lower, the market is likely to fall on opening.
As soon as trading starts, the futures rate changes and the predictive effect of fair value dissipates over the next few minutes. If you place orders for the purchase of shares at the opening of the market, fair value is an important input to help you determine the price you should pay for your shares.
Adjustments to Futures Value
To determine the fair value of the stock market for investors wanting to purchase shares, the value of the futures has to be adjusted because the investor who purchases futures is not in the same position as one who buys shares. The futures investor only has to put down the money to buy the futures while the investor who purchases shares has to pay for them.
Interest and Dividends
Since fair value is the amount you have to pay to buy the stocks corresponding to the futures, you have to adjust the value of the futures to reflect the interest paid by a theoretical investor who buys the stocks and the dividends the investor receives.
To make this adjustment, you take the quoted price of the relevant futures and add the amount required to finance this price until the next futures expiry date. You then subtract the dividends due over this period. The result gives you a fair market value that you can compare to the value of the corresponding futures.
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