The Definition of "Fair Value" in the Stock Market

Fair value is a good indicator of the stock market's movement.

For every major stock market index, such as S&P 500 or Dow Jones Industrial Average, there is a corresponding futures index. Fair value is the ideal price of the futures contract on a market index. It is a good indicator of the next day's stock market movement.

Futures

Futures are contracts to buy or sell an asset at a predetermined future date and price. In the context of the stock market indexes, futures are bets on the movement of an index. The largest market for futures in the U.S. is in Chicago.

How Fair Value is Calculated

The relationship between the futures index and the underlying one is worked out by adding the cost of borrowing the money to buy all the stocks in an index and subtracting what those stocks pay in dividends. In an ideal situation--that's fair value--it makes no difference to investors whether they own the real stocks or the futures contract.

Significance

The fair value factor is calculated by large investment banks and brokerages at the end of each trading day on the stock market. If the futures index is above fair value, the underlying index will probably go up the following morning. Conversely, if the futures index is below fair value, the index will go down.

References

• CNN Money: Fair value for dummies
• Investopedia: What Does Futures Mean?

Resources

• All Stocks: What Is "Fair Value?"