Fair Value and the S&P 500 Futures

I get a lot of email from readers trying to understand the effect S&P 500 futures trading has on the market open. I mean a lot of email. In fact, the only thing I get asked about more often is after-hours trading, a marginal and often murky institutional practice that this column has addressed elsewhere, and that promises to go mainstream sooner than a lot of sensible people would like to see.

Until now, I've been responding individually to readers with fair value questions, pointing them to a column my MonEmailbag predecessor, Herb Greenberg, wrote last fall on the subject. But the questions keep coming, so this week I thought we'd give it another go.

Reader Dave Webb plays our Everyman this week. He writes: "Would you discuss how pre-opening fair value and S&P 500 futures numbers are determined? CNBC continuously reports the S&P futures and occasionally offers an "Oh, by-the-way" comment on fair value, which can change the pre-opening picture entirely. Why?"

I suppose that so many people are interested in fair value in relation to S&P 500 futures because it seems such a skeleton key for the market's early performance, like a Quiz Show envelope postmarked 15 minutes before the open. And, in a way, the fair-value effect is that predictable, though there's not much the individual investor can do to capitalize on it.

Let's start with the basics of the S&P 500 futures. These contracts are essentially bets on where the S&P 500 index -- also called "the cash" by the initiated -- will be at a given point in the future. People always look at the next-expiring contract, or the "front month," when calculating fair value. Right now, the front month is the futures contract expiring in September. At expiration, the difference between the futures contract and the actual S&P 500 index is settled in cash.

People trade these contracts during the day on the Chicago Mercantile Exchange. But other, much lonlier people trade them overnight on the CME's GLOBEX2 electronic trading system. As many an individual investor will learn when the major exchanges introduce extended trading hours, after-hours markets are thinly traded, making the securities traded on them subject to fairly wide price swings. That's the case with the S&P 500 futures, and it's largely the overnight shift of their price in relation to what they're "really worth" that causes the big market indices to pop or drop at the open.

If you think the phrase "what they're really worth" is a bit subjective, you're right. As much as some will try to persuade you otherwise, finance and economics are more like sets of competing arguments than bodies of inscrutable truths. The same is true with formulas for calculating fair value; you'll find several versions. CNBC lists the following on its Web site:

Fair Value = Index Price [1+(Interest Rate - Dividend Rate) (Days 'Til Expiration / 360)]

HL Camp, which does research on program trading, cites a formula used by Vanderbilt University's Professor Hans Stoll:

Fair Value = Index Price [1 + (Total Interest Paid - Dividends Paid)]

And the CME gives us this equation:

Fair Value= Index Price [1 + Interest Rate (Days 'Til Expiration / 365)] - Dividends Paid

But basically, it all boils down to this: Add the value of the S&P 500 index to the interest you'd pay on the money you borrowed to buy them. Then subtract any dividends you'd receive on the stocks if you owned them individually instead of through a derivative (which doesn't pay those dividends).

Now, what would you do if the price of S&P 500 futures moved significantly higher than their "fair value?" If you were smart, you'd sell them, and replace them by buying up the relatively cheap underlying assets -- that is, the stocks that make up the S&P 500. Conversely, when the futures are trading significantly lower than fair value, you sell the underlying stocks in favor of the bargain futures.

Institutions have computerized trading systems that carry out this sort of arbitrage when futures prices and fair value get out of whack. Just how out of whack they have to get for this effect to happen varies between trading programs. But when the difference gets extreme, the effect is unmistakable. The major proxies pop or drop noticeably at the opening bell.

All this said, don't start placing buy orders on S&P 500 stocks when you hear Mark Haines saying that the futures are 10 points above fair value. By the time your order gets executed, the lightening-fast trading programs will have already done their work.

Memo: Have a dumb question relating to finance? Have a problem with something I've written? Send it to [e-mail], and I'll do my best to answer. Include your full name, and please, no questions seeking personal financial advice or regarding personal brokerage disputes. And this reminder: Because of the volume of mail, personal replies can't be guaranteed.

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