Determining the relevant fair value(s) of S&P 500 futures: A case study approach

✍ Scribed by Ira G. Kawaller

• Publisher: John Wiley and Sons
• Year: 1991
• Tongue: English
• Weight: 538 KB
• Volume: 11
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.3990110405

✦ Synopsis

A termination of the futures' break-even price or fair value. Conceptually, being able to sell futures at prices above the break-even, or to buy futures at prices below the break-even, offers opportunity for incremental gain. This article points out an important, though widely unappreciated, caveat. That is, no single break-even price is universally appropriate. Put another way, the break-even price for a given institution depends on the motivation of that firm as well as on its marginal funding and investing yield alternatives.

In this article, five differentiated objects are identified, and the calculations of the respective break-even futures prices are provided. The various objectives are: (a) to generate profits from arbitrage activities, (b) to create synthetic money market instruments, (c) to reduce exposure to equities, (d) to increase equity exposure, and (e) to maintain equity exposure using the most cost-effective instrument via stock/futures substitution. All of these objectives have the same conceptual starting point, which relates to the fact that a combined long stockhhort futures position generates a money market return composed of the dividends on the stock position as well as the basis' adjustment of the futures contract. Under the simplified assumptions of zero transactions costs and equal marginal borrowing and lending rates, the underlying spot/features relationship can be expressed as follows:

The author appreciates helpful comments from Dan Siege1 and two anonymous reviewers. '"Basis," in this article, is defined as the futures price minus the spot index value. Elsewhere, the calculation might be made with the two prices reversed.