Suppose that the Nifty 50 index is trading at Rs. 25,000, but the futures contract quotes are Rs. 25,080. Is that because of the price or for some other financial reason?
This is partly due to the fact that futures are valued at their fair value. Futures prices include time to expiration, dividends expected, financing costs and the spot price. Market prices can also deviate from their theoretical values due to demand, supply and trader positioning.
Beginners will find fair value useful to better understand futures prices, and for more advanced traders, it is a way to assess market trades.
The fair value of futures is a term used to describe the value of a futures contract.
Fair value of futures is the theoretical value of a futures contract based on the expected dividends, time to expiration, financing costs, and underlying spot price. It is helpful for traders to compare it with the actual market price to see if a contract is trading at a premium or discount.
What is the Fair Value of Futures? Quick Answer
Fair value: An estimate of the theoretical price of a futures contract, based on the spot price of the underlying asset and the cost of carrying the asset until the contract’s maturity.
The financing cost, for instance, may cause a stock valued at ₹1,000 to have a futures fair value of more than ₹1,000 for one month. That can be lowered by expected dividends.
Key terms:
Spot price: Price of the asset to be sold on the spot.
Cost of carry: The net cost of storing the asset till the expiry.
Basis: Difference between futures and spot prices.
Fair Value of Futures Formula
One of the simpler cost-of-carry formulas is:
F = S(1 + r)ᵀ
Where:
Theoretical futures price
S: Today’s spot price
r: Annual financing rate.
T: Number of years until the expiry of the test period.
D: Correct place value
If the dividend is being compounded annually:
F = S × e^((r − q)T)
In this case, q is the expected annual dividend yield. The actual calculations will depend on the pricing convention and dividend assumptions used.
The following factors can affect the fair value of the products:
| Factor | Typical effect |
| Higher financing costs | Raises fair value |
| Higher expected dividends | Lowers fair value |
| Longer time to expiry | Increases financing-cost impact |
| Higher spot price | Raises fair value |
| Demand and supply | Can influence market price away from fair value |
Not every futures contract that trades away from the spot price is necessarily “overpriced. This difference could be just the cost of carry.
Calculating fair value of futures – step-by-step example
Assume that the values of a stock are given by:
| Input | Assumed value |
| Spot price | ₹1,000 |
| Annual financing rate | 6% |
| Days to expiry | 30 |
| Dividend adjustment | ₹0 |
The first approximation is to take the simple interest:
F = S × (1 + r × d/365)
F = 1,000 × (1 + 0.06 × 30/365) ≈ ₹1,004.93
The estimated fair value is ₹1,004.93.
The market price is ₹7.07 higher than the estimate if futures trade at ₹1012. But those who wish to trade must take into consideration transaction costs, taxes, liquidity, margin requirements and the expectations of dividends.
This is a sample calculation, not a real one or guaranteed arbitrage.
How to interpret the result
Market price: Futures prices are higher than the fair value. Determine if the spread is greater than realistic trading expenses.
Market price lower than fair value: Futures are sold for less than market value. Reevaluate liquidity, dividend and financing assumptions.
Market price close to fair value: The price difference might be too narrow to profit on, minus costs and slippage.
What is the difference between the fair value and market price?
| Feature | Fair value | Market price |
| Meaning | Theoretical price | Actual traded price |
| Influenced by | The trading of a ‘spot’, the financing of a ‘spot’, the dividends and the expiry. | Orders, liquidity, expectations |
| Changes | In the event of changes in model inputs | With market movements |
| Purpose | Pricing benchmark | Actual execution |
| Guarantees profit? | No | No |
Prosperity advice: Fair value is a guideline and not a price forecast. Trading costs, assumptions that are imperfect in theory, or changes in demand can prevent market prices from being equal to the theoretical value.
This is the eighth topic in the series of lessons.
This is lesson #8 in the series.
Estimating the fair value of stock requires consideration of the earnings, cash flows, growth, assets, and comparable valuations of a company.
Fair value of futures is the theoretical value of a futures contract based on the futures underlying asset and the carrying costs of the futures asset until maturity.
Comparison
| Fair value of stock | The fair value of futures. | |
| Focus | Company’s estimated worth | Theoretical futures price |
| Inputs | Earnings, cash flow, growth, risk | Spot, interest, dividends and expiry. |
| Methods | A form of valuation that uses discounted cash flow methodology and valuation multiples. | Cost-of-carry model |
| Use | Investment analysis | Futures pricing |
How to determine the fair value of a stock.
To learn about determining the fair value of a stock, here’s what you need to do:
Examine the sales, the profit, the debt and the cash flow.
Make realistic assumptions to estimate future growth.
Select an approach (DCF, multiples).
Benchmark the company against its competitors.
Don’t see the result as a ‘true’ price, but rather as an approximation.
A fair value of the stock calculator can make calculations easy, however there are inputs and assumptions that will warrant the result. Use a futures calculator, which includes spot price, financing rate, expiry and dividends.
Why is Fair Value important in Trading?
Fair value assists traders in analysing price discrepancies instead of solely on the market sentiment.
Determine pricing gaps – market price versus theoretical price.
Know premiums and discounts: Compare futures with underlying assets.
Consider the cost of arbitrage: Determine if the hedged trade is still profitable after costs.
Compare expiries: See the time and cost of finance.
Enhance trade planning: fair value + technical analysis + volume.
A realistic trading situation
Let us assume that Nifty spot is 25,000, estimated futures fair value is 25,060, and futures price is 25,100.
Do not immediately sell futures, before doing so, verify the following: Is the financing date correct? Is the expiration date correct? Are dividends accounted for? Are there adequate transaction costs? Is there enough liquidity on both markets?
The margin needs to be studied and is not a profit bag. Coordinated positions, appropriate execution, and realistic cost calculations are all required for arbitrage.
Common Mistakes that Traders Should Avoid
- Dividend Ignorance: Can influence equity futures price.
- Wrong expiry: The period of financing for contracts varies.
- Mixing up premium with overvaluation: futures that are higher than spot can still be cheap.
- Neglecting costs: Appreciated opportunities can simply disappear due to brokerage, taxes, spreads and slippage.
- Margin leverage: Big gains or losses can occur due to small price changes.
- Fair value is a target rather than a fixed price: Prices do not have to come back to fair value immediately.
Risk management checklist
- Determine fair value with appropriate inputs.
- Compare with market value and calculate the trading costs.
- Set a maximum loss value.Establish a Maximum Tolerable Loss.
- Review margin and liquidity requirements.
- Do check your trade thesis before trading.
Learn Futures Pricing with Ruchir Gupta Trading Academy
Once you know the formula, it’s time to begin applying it. It takes practice, discipline and an awareness of risk to apply it in live markets.
In Ruchir Gupta Trading Academy, the students will learn to know the stock market in a structured way and learn intraday trading, options trading, technical analysis and market behaviour.
Learning should transcend entry points. Another aspect traders should know is about spot-futures relationship, position sizing, discipline, and risk management.
Join the Stock Market Course by Ruchir Gupta that offers intraday trading, options trading, technical analysis, live training, and mentorship. Look over the curriculum prior to joining. There are no guarantees in trading profits in any course.
Further learning – trusted resources.
The Equity derivatives settlement mechanism is provided by NSE India.
Zerodha Varsity: Futures Pricing and Spot Futures parity.
The Price is the final step in the UBT process.
The reasons futures prices vary from spot prices are due to the fair value of futures. Traders can compare the prices intelligently by taking into account financing, dividends, expiry, and market conditions.
Don’t forget to make realistic assumptions, consider fair value versus market value, and consider the costs associated with trading, and consider the cost of trading as well as risk management.
Visit Ruchir Gupta Trading Academy to enhance the market knowledge and learn to analyse the market and trade with a strategy.
Disclaimer: The information provided is not to be considered investment advice. Trading futures is extremely risky.
