Introduction to Marking to Market
Marking to market also called MTM is a technique used in the measurement of the fair value of assets and liabilities which can change or deviate over a period of time and this helps in the appraisal of a firm or a company’s present financial condition based on a realistic approach, which is again dependant on prevailing condition in the market.
Explanation of Marking to Market
Marking to market gives a more realistic value about the assets of a business or a company depicting the current valuation of the asset which tells us how much will the company receive in exchange of the assets based on the prevailing conditions in the market. The drawback with mark to market is that during volatile or unstable market conditions it may not rightly give the correct valuation of the assets. The difference between mark to market and historical accounting cost is that mark to market is more of a forward-looking approach whereas historical accounting maintains the cost of the asset at its base price or original price.
Mark to market is also used in the field of futures trading where on a daily basis contract are marked to market. Even is the security trading mark to market involves recording the price of a security or a portfolio to depict the market value of the security instead of the book value. In personal accounting to we use the mark to a market where the market value of an asset is equivalent to the cost of replacement. Thus we see in so many fields we use this concept ranging from securities such as futures, stocks, and mutual funds which help us show the current market value of these investments.
Examples of Marking to Market
A very simple example to explain the concept of mark to market can be a scenario of stock market investing. Suppose a trader has purchased 1000 shares of a company at $5 per share which makes his investment as $5000. Thus we see the book value of his investment is $5000. Now in the day of trade after the purchase was mad the price of the share fell to $4 per share. Thus the mark to the market value of his investment now stands at $4000 even though the book value is $5000. Thereby on that day on a more realistic approach, his investment stands at $4000 based on mark to market methodology.
Marking to Market in Futures Trading
Mark to market in futures trading basically involves two steps which are as follows:
- Determining settlement price: Different assets will have the different methodology to determine its settlement price. However, the common practice is to take the average of the traded prices for the day where few of the last transactions of the day are considered. The closing price here is not taken into consideration since it can be a lot manipulative to drive the price to a certain direction. Thus averaging out helps to reduce these kinds of manipulations.
- Realization of profit/loss: The profit or loss realization is generally dependent on the average of the price considered as the settlement price and the price which was pre-agreed at the time of entering the contract.
- The purpose of marking to market in futures is to ensure all margin accounts have proper funding available. If the mark to market price is lower than the purchase price the future holder is going for a loss and vice versa.
Importance of Marking to Market
The importance are as follows:
- It gives a realistic picture of the current value of the asset of the firm or company which the firm is going to receive in exchange of the assets based on the prevailing market conditions.
- It prevents the company from bloating or inflating the actual net worth and showing an unrealistic picture.
- It is also considered to be an efficient accounting tool to record the value of an asset with regards to the prevailing market price.
- In futures trading, it plays a vital role because it helps to determine whether an investor has made money or lost money in the trade.
- It is used in future contracts which are very vital for investors who are trading with futures in the margin accounts.
Marking to Market vs Historical Cost
Mark to market is more of a forward-looking approach where the value of assets are recorded on a realistic basis based on present market condition whereas in historical cost approach the value of assets are recorded in the financial statements based on the original price or base price at which it was purchased or acquired. In historical cost, depreciation gets calculated on historical cost whereas in mark to market depreciation is calculated on the fair value. Historical cost is nothing but the original transaction price and thus easy to identify whereas mark to market cost needs some understanding and calculation to identify the fair value. Historical cost measures the valuation of the original cost of the asset whereas mark to market cost, on the other hand, measures the existing market value of the asset.
Advantages and Disadvantages
Some of the advantages and disadvantages are as follows:
The advantages are as follows:
- It gives a more realistic measure of the current market value of the asset which may be different than the actual recorded book value.
- It is very useful for investors involved in future trading to determine how much money they have made or lost during the day.
- Mark to market accounting reflects the true value in the balance sheet of financial institutions.
- In fields of future trading, it minimizes the administrative overhead of the exchange.
- Mark to market minimizes the daily counterparty risk for investors in future contracts.
The disadvantages are as follows:
- Expected earnings are difficult to be estimated as an investor cannot judge if the gains or losses are due to shocks in yield or shocks in cash flows.
- It cannot give correct valuation at times of volatility in the market or in unstable market conditions.
- It needs continuous checks and monitoring by complex systems that cannot be afforded by smaller institutions.
- It can lead to a troubling situation during times of uncertainty which can cause the value to assets to move dramatically.
It is a very effective methodology to estimate the real value of assets thought it has both pros and cons to it. It is a forward-looking approach and thus is preferred widely by investors especially in the field of futures trading. It not only helps investors to estimate how much money they have lost or gained during a day but also prevents investors from counterparty risk.
This is a guide to Marking to Market. Here we also discuss the introduction of Marking to Market along with importance, advantages, and disadvantages. You may also have a look at the following articles to learn more –