If you’ve ever been looking at pre-markets while drinking your morning coffee and wondered exactly what “fair value” means, you’re not alone. The term became a commonly used phrase in business journalism in the early 2000s. It can be used in a few different ways depending on context, but in essence, fair value is a tool used as a “weather report” for the market day, according to Allen Wastler of CNBC.
Fair value is commonly used by investors attempting to predict how the markets will open for the day. In this context, CNBC defines fair value as “a tool used by investors to understand the relationship between the value of futures contracts and the current price of a stock.” Fair value generally is listed alongside futures data in pre-market indicators, a set of data that forecasts how the day’s trading is likely to go.
Fair value is an integral element in the futures contract market. Futures contracts simply translate into bets on how much a stock or commodity will be worth in the future. When investors buy or sell a futures contracts, they are betting on the future worth of the commodities the contracts represent. Some markets even allow investors to bet futures contracts on the weather. The futures market opened in 1982 at the Chicago Mercantile Exchange. Major indexes — including the S&P 500, the Dow Jones Industrial Average and the Nasdaq — all have futures contracts. Investors use futures in conjunction with fair value to predict and shield themselves from major market shifts.
Futures and Fair Value
In the futures market context, fair value is defined by Investopedia as “the relationship between the futures contract on a market index and the actual value of the index.” If the futures are higher than fair value, investors bet that the market index will increase and vice versa. The stocks underlying an index, such as the Dow or the Nasdaq, have costs from buying and holding fees and benefits from dividends, neither of which show up in the index right away. Fair value takes costs, benefits and interest into account, thus creating differences between index levels and fair values. So, while futures predict shifts in market direction, fair value defines the “starting line” of those shifts, according to CNBC.
Fair Value and Taxes
Fair value has a slightly different definition when it comes to taxes. When employees receive compensation in the form of stock, it's essential to determine the stock’s fair market value. Fairmark’s definition, often used by tax accountants, is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” The fair value of publicly traded stock is not calculated in the same way as the fair value of privately held stock. The fair value of publicly traded stock is identified by averaging the high and low selling prices over a specified number of trading days. Privately held stock’s fair value is most often determined by the amount exchanged in a recent arm’s length sale, or a sale to a neutral buyer.
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