The turbulent and volatile markets we navigate today present investors and traders with lots of challenges. Among the main ones is the increasing complexity of ensuring fair representation of the portfolio’s value. So is the case with the pricing of separate constituents, including shares, futures contracts, and other securities. To overcome this, the financial world has adopted the mark to market (MTM) methodology. The following guide focuses on how marking to market benefits retail and institutional derivatives traders. We’ll examine how it works and how it affects the value of assets.
Mark to market is a method of measuring values subject to periodic fluctuations to provide a fair representation of the asset or entity’s current state.
Today, mark to market is used in investing (stocks, futures contracts, mutual funds) and accounting (assets and liabilities).
In trading, we use it to better reflect the current market value of a security, account, or portfolio instead of its book value. To do that, it adjusts the value of the instrument or the account to the current volatility and market performance. The goal is to provide a fairer representation of the portfolio’s health. For example, if the recent market developments drag the account below the required level, the trader receives a margin call. In the context of mutual funds, mark to market is used daily to help provide a better idea of the funds’ Net Asset Value (NAV).
For accounting purposes, mark to market helps present a more transparent representation of the current value of the company’s assets and liabilities, based on today’s market conditions.
What is the Origin of Mark to Market?
The mark to market methodology was first introduced in the 1800s in the United States. At the time, it was the usual practice of bookkeepers.
However, after a while, many started attributing the prerequisites for the Great Depression, the instability in the economic system, and banks’ mass collapse to the MTM. In 1938, its use was discontinued, but in the 1980s, it was reintroduced.
This time, it also wasn’t a smooth ride. The growing popularity of the methodology also exposed its loopholes. When many corporations and banks started applying mark to market, they found weaknesses in its design over time. These weaknesses are vulnerable to accounting fraud, mainly when the real day-to-day asset value couldn’t be determined objectively. One such example is the case of crude oil futures, where the instrument’s price derives from another commodity).
The epitome of a wrongful application of mark to market accounting principles, for example, was the biggest scandal in corporate history – the fall of Enron.
After that case, regulators introduced changes in the mark to market method, including implementing stricter accounting standards, more explicit financial reporting, independent auditing, more robust internal controls, etc.
Today, mark to market is an officially-recognized and widely-adopted methodology for tracking the fair and actual value of accounts and an entity or individual’s current financial situation.
What is The Need For Mark to Market?
The need for a method like mark to market is to prevent market manipulations from happening. Alternatively, to ensure maximum transparency by fairly representing the real value of an asset or account or the company’s financial situation at any point in time.
If we go a few steps back, we could say that market information’s main issue is its relevance. Market participants often rely on outdated and historical data to make evaluations or predictions for the current or a future period. During times with high volatility or market dynamics like the ones we have been going through in the last two decades, the information must be adequate and fresh.
That is why mark to market was introduced. It was an alternative to the popular historical cost accounting methodology, where the basis for an asset’s value was its original purchase cost. Understandably, this type of evaluation can’t provide a fair representation of the subject’s current state. Alternatively, it can’t accurately calculate what it costs today. That’s because the information is outdated and irrelevant to the current market environment.
However, if we focus on the particular reasons why mark to market is necessary, one of them stands out. It prevents the accumulation of excessive risk for the specific entity, trading account, or portfolio.
By having access to fair and accurate information about the state of an asset or an entity, market participants can better predict its future trajectory.
How Does Mark to Market Work?
Mark to market works differently based on its use-case. Let’s take a look at several examples.
In the financial industry, there is always the default risk. Once a default occurs, the loan must be classified as a non-performing asset or as bad debt. The company must establish a separate (contra assets) account that marks its assets’ value down. Mark to market helps do that fairly and accurately.
In the context of companies selling goods and offering promotions or discounts to quickly collect account receivables, the mark to market requires to record both a credit to the sales revenue and debit to the account receivables. The values are based on the estimated number of customers likely to take advantage of the discount.
In personal accounting practices, the market value of an asset is considered equal to its replacement cost. For example, the insurance on your home or vehicle usually includes the value it would need to be rebuilt/repaired.
When it comes to securities, the mark to market methodology requires using fair value instead of book value. For example, the stocks in your brokerage account are marked to market at the end of each day. The case is quite similar to futures contracts and mutual funds, where the value is calculated with the closing bell.
Mark to market Pros and Cons
Like any other metric or methodology in the financial world, mark to market isn’t flawless. While it helps overcome some issues, it also falls short on some fronts. Let’s check out the main pros and cons to find more about how trustworthy mark to market is:
Reflects the actual value of an asset
The asset’s value is based on the current market environment, which makes it genuine and representative. It doesn’t rely on history or any data that might not be relevant to the current situation and factors that might affect the value of the account or assets.
Reduces the levels of risk within the portfolio or the entity
Mark to market can serve as a real-time warning system for default or insolvency risk. It can alert whether the current state of the company’s portfolio is good enough to justify investments or predict future performance and exposure to unfavorable market conditions.
Beneficial for every side that adopts it
Mark to market brings advantages on a micro and macro level.
Brokers, for example, can keep track of the account balances of their clients and prevent defaults. On the other hand, investors can take advantage of margin trading, which is way easier to monitor and control than before introducing the mark to market methodology.
With banks, businesses selling goods, financial organizations, auditors, and regulators, the mark to market methodology provides a unified procedure to keep track of the current state of entities and their financial health fairly and transparently.
Can be inaccurate during volatile periods
Volatility tends to throw pricing mechanics out of bounds. The bigger and the more fluctuations, the more distorted and unstable the portfolio or asset’s value estimations are.
Can’t contextualize information
Although this isn’t necessarily a substantial disadvantage, the truth is mark to market can’t tell how the price at the closing bell was formed. For example, it fails to reveal whether there was a significant and sudden influx of buyers and sellers, what changes had it seen throughout the trading session, what market conditions were surrounding this price formation, etc.
Momentum dependency that can harm valuations during economic distress
Companies that are forced to calculate selling prices for their assets (e.g., banks with bad loans triggering insolvency procedures) during economic downturns, low liquidity, or market uncertainty periods might expect unfavorable valuations (usually lower than the actual value).
Examples of Mark to Market
Imagine that you are holding 20 shares of company ABC, purchased for $5 each. Currently, it trades at $6 per share. The mark to market value equals $120 (20 shares x the current price of $6). On the other hand, if the stock drops to $4 per share, then the mark to market equals $80, and the investor has an unrealized loss of $20.
If you are using the book value method, then the estimation would require a calculation based on the price at the time of purchase and multiplying it by the number of purchased shares. Understandably, mark to market is a much more accurate method than book value.
Mark to Market in Futures Trading
Assume you are a futures trader and you are making your first deposit with your preferred exchange. The deposited funds are used as a “margin” or a protection for the exchange against potential losses. Think of the margin as a threshold that you should not fall below.
At the end of each day (with exchanges like the CME even twice per day), the futures contracts in your portfolio are marked to their present market value (mark to market). If the market developments were favorable, you would be on the winning side; thus, your account’s value would increase as the exchange pays you the profits. On the other hand, if your futures contracts have dropped in value, you would be suffering losses, and the exchange would be charging your account with the deposited margin.
If the loss is severe and your account’s value dives below the minimum margin requirement, you will receive a margin call. The margin call is the exchange urging you to deposit additional funds to cover the minimum capital requirement. Otherwise, you default.
Example of Mark to Market in Futures Trading
Here is a practical example of how mark to market is applied within futures contracts. As with any other instrument, trading futures contracts requires two sides – a buyer and a seller. If the contract price goes up at the end of the day, the buyers’ account value increases, while that of the short accounts decreases, and vice-versa.
Let’s say that you are interested in trading wheat, and you want to hedge against falling prices of the underlying commodity. You decide to sell 5 contracts (1 contract = 5,000 bushels) at a current price of $4. The trade will then equal $100,000.
Here is the maths behind the trade and how the failing prices will affect your account balance:
As you can see, each fall in the wheat futures contract value results in an increase in your account balance and vice-versa.
The mark to market calculation process continues until the futures contract’s expiration date or until you decide to close your position.
The Effect of Institutional Investors
But futures trading doesn’t happen only on traditional exchanges. Institutions and large-scale investors prefer trading derivatives OTC. However, the case with OTC derivatives trading is way more complicated. On these markets, the price isn’t regulated by the trading venue but is instead negotiated between buyers and sellers. What this means is you can’t objectively determine or get the market price immediately. Besides, the price should also include quantification of default or “nonperformance risk.” To better navigate this, market participants use sophisticated computer models that can provide relative pricing information that, more often than not, is close to the one they will be paying in the end.
In a nutshell, with futures trading, mark to market is to eliminate the credit risk. However, applying it adequately requires the involvement of exchanges or institutional investors, trading OTC. That’s because only they can afford the use of the necessary sophisticated monitoring systems.
How Does it Affect Your Trading?
The main way mark to market affects your trading is by providing you more flexibility and granting higher buying power thanks to margin trading. That way, it allows you to capitalize on existing opportunities by investing more than you currently have.
For example, suppose you think that there is major news coming out. Something that will potentially have a major positive effect on the price of TSLA, AAPL, CL, or any other instrument. In that case, you can take “credit” from the broker/exchange and buy more than you actually can afford. The margin varies based on the provider and the trader instrument.
Bear in mind that margin trading is a two-edged sword. While it can be very lucrative, it can also pose significant risks as the losses are multiplied. This means that even a single wrongly-timed decision or market move can wipe out your whole account balance.
However, if applied cautiously and by experienced traders, margin trading can help you pile up significant returns. For an opportunity like this, you have to thank the mark to market methodology.
Mark to Market Outside of Derivatives Trading
Brokers use mark to market within other types of trading activity (stocks, options, or other securities) to grant investors access to margin accounts. Alternatively, to allow them to borrow funds and trade on credit to multiply their purchasing power.
The use of mark to market is to evaluate the collateral margin requirement the trader has to be eligible to trade on credit. In exchange for that opportunity, he has an obligation to pay interest and maintain his account balance over the threshold. The process is similar to bank loans.
The mark to market is computed at the end of the trading day. If the value falls below the threshold set by the broker, the trader receives a margin call. If he fails to deposit additional funds, his account is liquidated.
Mark to Market Accounting
In accounting, the mark to market methodology came to replace the historical cost one. That’s because it provides a more accurate and relevant representation of an entity’s current financial health.
Historical cost accounting uses the original purchase cost to calculate the assets’ value. Meanwhile, the mark to market accounting methodology focuses on their current value. It does so based on prevailing market conditions.
This helps us understand why mark to market accounting is much more efficient and accurate. The reason is that it reveals the real amount you can exchange assets for today. That’s because it isn’t based on outdated information from a few years back.
This isn’t to say mark to market is the perfect methodology. Just the opposite – it was in the core of the greatest corporate scandal in modern history.
During the 1990s, Enron used mark to market accounting to exploit an existing loophole and skyrocket its natural gas business profits. Once long-term contracts were signed, the company estimated the income based on the net future cash flow’s present value. However, this resulted in the intentional creation of discrepancies between the cash and the reported profits. In the end, investors were receiving deceiving reports.
Mark to market allowed Enron to record income that had never been received. The goal of this was to increase the company’s financial earnings and boost its share price. However, this led to a snowball effect. It forced the company to report growing earnings over time to maintain a steady positive rate. The end of this story is well-known to anyone.
However, in 2002 agencies introduced many necessary regulatory changes to improve the accounting standard.
2009 solved another issue with the mark to market methodology. It addressed the mortgage-backed securities (MBS) that the banks held in excessive amounts during the financial crisis. Since the markets for these instruments had already disappeared, the assets in the banks’ books couldn’t be valued accurately. The Financial Accounting Standards Board (FASB) introduced new guidelines. This allowed market entities to evaluate the prices based on what they would have received in an orderly market, rather than during a crisis or forced liquidation.
After that, there haven’t been any major reported issues with mark to market accounting.
Mark to market is a crucial cog in the market mechanics nowadays. It has helped transform the way we trade and how companies report their financial results. It contributed to improving the financial system’s stability by reducing the default risk and ensuring more transparent oversight and control.
Although you might not have to deal with the mark to market terminology daily, it is worth understanding what it is and why marking to market is so essential for the well-being of traders, institutional investors, financial organizations, and more.