Interpreting futures fair value in the premarket Video Lecture - Economics

In the first video
on futures fair value
we learned that it was the
price at which an investor would
be neutral between buying
the stock on the actual stock
market or buying the front
month futures contract.
What I want to do
in this video is
talk about how
does one interpret
the fair value, especially
relative to the futures price.
So let's say you
wake up one morning.
The market hasn't opened yet,
the stock market hasn't opened,
and you see a quote like
this for stock ABCD.
The fair value, according to the
closing of yesterday's trading,
the fair value is $102,
but the futures market,
which usually has trading
hours beyond the regular market
and often times 24 hours,
so the futures market
trading price for the
front month future,
even though the fair value based
on yesterday's closing is 102,
the futures market is
trading it at $101.
So how would you
use that information
or how would one interpret
that information?
So in the futures market,
people are trading the futures
contract, they're buying
and selling at a price
below the fair value based
on yesterday's close price.
So what that means is is
that the market thinks
that this is actually no longer
the correct price of the stock.
They think that the
correct price of the stock
is the stock at
which they would be
neutral between that price
and this futures contract.
So I don't know what it is.
You would have to discount it
back by the risk-free rate,
but maybe it's something
like-- so this is implicitly
saying that the correct price
of the stock isn't $100.
if the futures
price was $102, it
would say that the
stock should be 100.
If the futures
prices is $101, it
means that maybe the stock
is something less than that.
Maybe if we do our math maybe
it implies a stock price of $99.
So the way you would potentially
act on it, although it's easier
said than done is
say, well, look.
That means that, at least
in the very early stages
once the market opens, the
stock is going to go down.
Now, your initial reaction
might be saying, wow,
this is really amazing.
This is some type of
a future indicator
and it is a pretty
strong future indicator.
When you see this, when you see
the actual price of the future
being below the fair
value, it is very likely
that the stock will open down.
Unfortunately, you have many,
many very sophisticated,
high-frequency
traders who already
have their computers
set up to look
at this type of a
discrepancy and they're
going to be ultra
fast and they're
optimizing how fast their
bandwidth is so that they
can do these in a
matter of split seconds.
So it's very,
very, very unlikely
that an average investor or
even a reasonably sophisticated
investor will be able
to take advantage
of this type of an arbitrage
or this type of an expected
arbitrage to know that this
price is likely to go down.
Now, if the opposite
happened and let's
say that the fair
value is $102, which
implies the fair value of the
front month futures contract
is $102, which implies
$100 stock price.
Let's say that the
futures is actually
trading even though
the fair value is $102,
let's say that it
is trading at $105.
So this is a situation that
since the market closed,
the futures market
for some reason
thinks that the stock is
going to be worth more.
This would imply a
stock price of maybe,
I don't know what it might be.
I'm not going to do
the math exactly,
but maybe a price
of $103 or $104.
And so if you saw this
where the futures price is
above the fair value
in the pre-market,
that means that the
stock is likely to go up.
But once again, it's very
hard to take advantage
of because you're going to
see that movement very, very,
very quickly.