In Finance, what is a Fair Price?
Fair price is a financial term commonly used in two different contexts. One is as a synonym for fair value, a theoretically unbiased valuation of an asset which may differ from its current market price. A second meaning of fair price is that at which demand and supply for a futures contract are equal.
The fair price, or fair value, of an asset is an economic concept. It aims to give an objective valuation of the asset rather than simply going by the current market price. Whereas the market price is determined solely by supply and demand, the fair price takes into account the costs of the individual components of the asset. In the case of a business this could include land, machinery, stock and staff levels.
The fair price may also take into account the value of whatever is produced by an asset, whether that be production from a physical asset, or financial return from a financial asset. There may also be more subjective elements in assessing fair value, such as how useful an asset is to a particular potential buyer. For example, a fishmonger would place a higher value on a store with easy access to a port than a baker would place on the same store.
The most common use of fair value is in accounting terms. In one form of accounting, known as historical cost, firms must list their asset values based on what they actually paid for them. In a second form, mark-to-market, they must list the value based on what they are currently worth. While this is often done by looking at current market rates, it can also be done by calculating fair value. Most countries have strict rules about how this fair value must be calculated.
Fair price can also be used for futures contracts. These are assets which involve the right to buy a commodity at a set price on a future date. The fair price is defined as the one at which the demand for a particular type of futures contract is met exactly by those available for sale. In theory, this will be the prevailing market price at any time, but market imperfections mean that this isn't always the case.
The precise method of measuring this type of fair price varies depending on the commodity concerned. As a general rule, any method will take account of the current going market rate and the loss of interest that arises by having money tied up in a commodity. In the case of a stock-based contract, the fair price also takes into account the dividend payments which may be received by whomever holds the stock between now and the futures contract coming due.
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