Friday, July 30, 2010

The Fair Value of a Stock Market Index

The "Fair Value" of the S&P 500, Dow Jones, Nasdaq, and other indices is often compared to the "futures" of those same indices as an indication whether the stock market will open the day up or down from where it previously closed.  So what exactly is the "fair value" of a market index?  From Investopedia:  fair value "... refers to the relationship between the futures contract on a market index and the actual value of the index.  If futures are above fair value then traders are betting the market index will go higher, the opposite is true if futures are below fair value."  In other words, the Fair Value of a market index is its theoretical value, derived mathematically rather than by market forces.  (Yes, you say, but how do they calculate Fair Value?  Click this CME Group link http://www.cmegroup.com/trading/equity-index/fairvalue.html for the actual calculation.)  An analogy can be drawn from accounting principles: the fair value of a business or other asset for sale can likewise be mathematically determined according to internationally-accepted accounting standards, yet the actual value of that asset will be determined by bidders at the time of sale.  Until then, potential buyers can only speculate - and perhaps submit bids about that future price.