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Fair Value Adjustment A modified calculation approach is presented for the fair value of an equity index futures contract. The modified calculation takes into account the funding required to support the tail hedge that was not considered previously. In words, the change in the value of the futures contract and funding cost the hedge is equal to the change in the value of the index position. Now upon expiry the value of the futures contract must equal the index value, The arbitrageur establishes a short position of 100 futures contracts priced at and buys $37,997,917 of stock that costs $6,333 to fund overnight. On the next day the index falls to 1485.858, causing the arbitrageur to realize P&L of $-135. Over the life of the contract, the arbitrageur realizes a loss of $5247. The arbitrageur establishes a short position of 100 futures contracts priced at and buys $37,996,751 of equity as a hedge. When the index drops to 1485 the total P&L is 0 as predicted, and over the life of the contract there is no profit or loss, proving the analytics above. We recommend that the new method be approved in order to determine the fair value of futures contracts for index arbitrage. This is important because the current method undervalues predominantly short futures positions creating erosion of P&L over the life of the contract.
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