The core driver of a financial market is: change.
Every second the market is active, the price of a security is updated. However, in this sea of change, it can sometimes be challenging to gain an understanding of its actual value. This is where mark-to-market tactics begin. We mark an asset's market price at a point in time, thereby creating a record.
The practice allows one to assess an asset's fair price.
This simple accounting strategy has benefitted several industries:
Financial Services
The sector of financial services operates in the market of debt. Where there is debt, there is a risk of non-repayment. This is why most companies operating in the sector regularly update their books to reflect the accurate state of the market. It is a mark-to-market strategy that allows them to understand asset performance regularly.Online Shopping
We have all shopped on Amazon and Flipkart during their discount festivals. And the ingenious among us have always double-checked our deals via price tracker websites. Those websites use mark-to-market strategies by recording the market prices of most products, thereby allowing you to see price history easily.Insurance
For individuals, the market value of any currently held asset is equal to its replacement cost. Most insurance companies work on mark-to-market principles to offer you financial protection. Homeowner insurance will include the cost of rebuilding the home, not its historical price or the price paid for the property.Investing
A few securities, like futures and mutual funds, are also marked-to-market. For example, a futures contract may have clauses built in to trigger when the price hits a certain target. Mutual funds collect several securities based on rigorous financial analysis and mark their prices to the market, offering the user returns on the same.Real-Life Examples of Mark-to-Market
- Consider the story of Priya. She is a trader with quite a diverse portfolio, but she does not have the time daily to check in on her investments, assessing them at the end of every month. Whichever exchange Priya has an account on though, is always tracking the securities she has invested in. The exchange marks the asset's opening and closing market prices every day in her account, automatically depositing gains and deducting losses.
- Abdul is a corn farmer who takes a short position on 10 futures contracts. In case it's a bad year for corn, Abdul can at least protect himself from some financial damage. If each contract represents 2,000 kilograms of corn, Abdul is betting that the price of 20,000 kilograms of corn will decrease in the coming months. So, if today is Dec 1 and the price of the contract is ₹48 on Dec 1, Abdul will buy ₹48 * 20,000 kilograms = ₹9,60,000 as of that day. That represents buying the contract at market value.
Benefits of Mark-to-Market
- • Accurately depicts an asset's value
- • Helps clear communication across all stakeholders
- • Increases competition by allowing rivals to track their competitors
- • Allows you to monitor your risk profile
- • Puts you in charge of leveraging your assets
Challenges of Mark-to-Market
- • Hard to interpret changes in price in times of volatility
- • Mark-to-Market strategies are susceptible to larger market forces
- • Selling prices & fair values may differ due to special considerations
Impact of Mark-to-Market on the 2008 Financial Crisis
The 2008 financial crisis was triggered by banks easing up on credit requirements in a bid to sell more mortgages. These mortgages would then be used as the underlying asset in mortgage-backed securities. As housing costs skyrocketed, the bank raised the prices of these mortgage-backed securities while continuing to offer easy loans. As a result, subprime mortgages were introduced to the system, that is, mortgages that carry a high risk of non-repayment. Now, when asset prices started falling, banks were forced to write down the values of their subprime securities by mark-to-market accounting. These values, which reflected market price, presented inflated numbers at the start of the bubble and deflated numbers when it burst. To save some of the largest financial institutions in the world from failing, the US Financial Accounting American Standards Board eased the mark-to-market accounting rule for a short period in 2009. Banks were allowed to keep the earlier values of mortgage-backed securities on their accounts. In the market, those values had plummeted and if the banks had marked them to market, it would have triggered the clauses in the derivatives contracts and devastated all stakeholders involved.Conclusion
In conclusion, tracking the current market prices of an asset is usually a reliable way of determining its fair value. You can manage your finances easily by using mark-to-market discipline to review your portfolio. Marking the market value of your portfolio on a monthly or quarterly basis can help you gain a deeper understanding of your holdings, rebalancing them if required. Open a Demat account with Angel One to add a vast range of assets to your portfolio. You can use our app to track your portfolio, mark prices to the market and use our Knowledge Center to access a vast pool of financial learning.
FAQs
What is meant by mark-to-market?
A method of accounting that involves marking the market value of a security. Mark-to-market is used to assess the fair value of securities, such as assets and liabilities, that are subject to change over time. By marking their prices to the market, it is possible to achieve a realistic appraisal of an institution's current financial situation.
How do you calculate mark-to-market?
Mark-to-market calculations generally assume that all open positions and transactions are closed the previous day while new positions are opened the next day.
What are MTM and P&L?
P&L stands for Profit & Loss, and it reflects the unrealised and realized profit/loss for that particular position, marked-to-market.
Is MTM a loss?
Losses registered to your portfolio under mark-to-market accounting are a representation of account entries rather than asset sales. So, if you hold a financial instrument at a value lower than its current market value, the total would be registered as a loss.
Is MTM profitable?
Mark-to-Market accounting is the daily settlement of profits and losses arising because of changes in a security's market value as long as it is held.
