What Is Mark to Market (MTM)?
Mark to market (MTM) is a measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution's or company's current financial situation.
In trading and investing, certain securities, such as futures and mutual funds, are also marked to market to show the current market value of these investments.
Understanding Mark to Market (MTM) and Mark to Market in Accounting
Mark to market is an accounting practice that involves recording the value of an asset to reflect its current market levels. At the end of the fiscal year, a company's annual financial statements must reflect the current market value of its accounts. For example, companies in the financial services industry may need to make adjustments to the assets account in the event that some borrowers default on their loans during the year. When these loans have been marked as bad debt, companies need to mark down their assets to the fair value. Also, a company that offers discounts to its customers in order to collect quickly on its accounts receivables will have to mark its current assets account to a lower value. Another good example of marking to market can be seen when a company issues bonds to lenders and investors. When interest rates rise, the bonds must be marked down since the lower coupon rates translate into a reduction in bond prices.
Problems can arise when the market-based measurement does not accurately reflect the underlying asset's true value. This can occur when a company is forced to calculate the selling price of its assets or liabilities during unfavorable or volatile times, as during a financial crisis. For example, if liquidity is low or investors are fearful, the current selling price of a bank's assets could be much lower than the actual value. The result would be a lower shareholders' equity.
This issue was seen during the financial crisis of 2008/09 when the mortgage-backed securities (MBS) held as assets on banks' balance sheets could not be valued efficiently as the markets for these securities had disappeared. In April of 2009, however, the Financial Accounting Standards Board (FASB) voted on and approved new guidelines that would allow for the valuation to be based on a price that would be received in an orderly market rather than a forced liquidation, starting in the first quarter of 2009.
Mark to Market in Investing
In securities trading, mark to market involves recording the price or value of a security, portfolio, or account to reflect the current market value rather than book value. This is done most often in futures accounts to ensure that margin requirements are being met. If the current market value causes the margin account to fall below its required level, the trader will be faced with a margin call.
An exchange marks traders' accounts to their market values daily by settling the gains and losses that result due to changes in the value of the security. There are two counterparties on either side of a futures contract - a long trader and a short trader. The trader who holds the long position in the futures contract is usually bullish, while the trader shorting the contract is considered bearish. If at the end of the day, the futures contract entered into goes down in value, the long account will be debited and the short account credited to reflect the change in value of the derivative. Conversely, an increase in value results in a credit to the account holding the long position and a debit to the short futures account.
For example, to hedge against falling commodity prices, a wheat farmer takes a short position in 10 wheat futures contracts on November 21, 2017. Since each contract represents 5,000 bushels, the farmer is hedging against a price decline of 50,000 bushels of wheat. If the price of one contract is $4.50 on November 21, 2017, the wheat farmer's account will be credited with $4.50 x 50,000 bushels = $225,000.
|Day||Futures Price||Change in Value||Gain/Loss||Cumulative Gain/Loss||Account Balance|
(Note that the Account Balance is marked daily using the Gain/Loss column, not the Cumulative Gain/Loss column).
Because the farmer has a short position in wheat futures, a fall in the value of the contract will result in a credit to his account. Likewise, an increase in value will result in a debit. For example, on Day 2, wheat futures increased by $4.55 - $4.50 = $0.05, resulting in a loss for the day of $0.05 x 50,000 bushels = $2,500. While this amount is debited from the farmer's account balance, the exact amount will be credited to the account of the trader on the other end of the transaction holding a long position on wheat futures.
The daily mark to market settlements will continue until the expiry date of the futures contract or until the farmer closes out his position by going long a contract with the same maturity.
Another security that is marked to market is mutual funds. Mutual funds are marked to market on a daily basis at the market close so that investors have a better idea of the fund's Net Asset Value (NAV).