Fair Value

The price at which Sita agreed to buy the apartment from Noor was Rs.1.1 crore. This is the price that Sita will pay at the expiry/maturity of the contract after 6 months. But is this the fair price, assuming the same apartment can be bought today for Rs 1 crore?

Let’s assume that the current bank interest rate is 6% pa. Keeping things simple and not counting in compounding, Sita will be able to earn 3% returns in 6 months on her investment. So if Sita invests Rs 1 crore in the bank today, she will have Rs 1.03 crore after 6 months. This is called the Fair Value of the futures contract. If the future contract was priced at Rs 1.03 crore, instead of Rs 1.1 crore, Sita would have been indifferent in buying the house today or after six months.

Simply put, fair value of any future contract is the amount that you will have at maturity of the contract, if you simply invest an amount equivalent to the current underlying price in the bank and earn the risk free rate on it.  

*We use 3month MIBOR for all our calculations