What is Mark to market?
Introduction:
Mark to market refers to a system of valuing assets, securities, portfolios or accounts by the most recent market price. It is a method of measuring the fair value of assets and portfolios that fluctuates over time. It provides a realistic picture of a company’s current financial situation based on a current market condition. It reflects current market value rather than book value of investments which leads to daily settlements of profits and losses.
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Steps in calculating Mark to Market:
֍Step1: Determining Settlement Price
Assets have different way of determining the settlement price but mostly the average of few trade prices are considered. Generally, the last few transactions are taken as it accounts for considerable activities of the day. Closing prices are not taken into consideration as they can be manipulated by traders to take the prices into a particular direction. To succumb this averaging is done to reduce the probabilities of manipulation.
֍Step 2: Realization of Profit / Loss
The average price taken as settlement price and pre agreed contract rate accounts for the realization of profit and loss.
Example
Let’s assume two parties are entering into futures contract involving 35 tons of oil at $160 per ton with a 6-month maturity. The value of security is (35 x $160) = $5600. On the next trading day, the price increased to $165 per ton. A long position trader will earn from trader in short position $175 ($165- $160) x 35 tons for that day. Alternatively, if the price decreases to $155, the difference of $175 will be collected by short position trader from long position trader.
Formulae’s used:
Change in value = Future Price of Current Day – Price as of Prior Day
Gain/loss = Change in Value * Total quantity involved
Cumulative Gain/Loss = Gain/Loss of the current day – Gain/Loss of Prior Day
Account Balance = Existing Balance +/- Cumulative Gain/Loss.
Benefits and drawbacks
Benefits:
- It gives an accurate representation of assets current value.
- Reduces counterparty risks for investors.
- Exchange administrative overheads are reduced.
- Daily settlements are made at the end of trading day thus leaving no outstanding obligations. This reduces the credit risk.
Drawbacks:
- Observation systems have to be used continuously which are very costly and hence can be afforded by large institutions only.
- The value of asset can drastically change due to unpredictable buying and selling patterns, thus creating uncertainty.
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Conclusion
Mark to Market aims to keep the marginal accounts funded. If the value of asset is below the purchase price than an investor faces loss and hence his account is debited to make it reach minimum or proportionate level, whereas if the price of asset is above purchasing price than investor gains from the investment and his margin account is credited. It ensures protection of exchanges that bear the risk of trades.
Author: Urvi Surti
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).
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