25 September 2010
Fair value is a rational, unbiased estimate of value of anything in an arms length deal.
It differs from market value. For e.g. Share X is quoted in the market at Rs. 50 and you think the fair value of it is Rs. 60. In the case of Share X, you may like to buy it as you notice that it is undervalued in the market. It is important to note that fair value is arrived at based on certain assumptions that you may have (called valuation model).
For options also you may try to find out what is the fair value and compare it with market value to take decisions. One of the acceptable models is Black Shcoles Merton Model.
I can give a small example how fair value differs.
Let us say an option to sell immediately (put option) for Share X at Rs. 100 is available in the market for a price of Rs. 7. You now see that current market price of Share X is only Rs. 50. You can see that the fair value of the option is much higher. Why? you can buy the option for Rs. 7 and buy the share for Rs. 50 and immediately exercise the option to sell and get Rs. 100 (You gain will be 100-50-7=43). Ideally the fair value of the option should be 7+43 = 50, so you found that fair value is above market value.
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