What is Mark to Market (MTM)?
Mark to market (MTM) is a method of measuring the fair value of accounts that can fluctuate 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 based on current market conditions.
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.
- Mark to market can present a more accurate figure for the current value of a company's assets, based on what the company might receive in exchange for the asset under current market conditions.
- However, during unfavorable or volatile times, MTM may not accurately represent an asset's true value in an orderly market.
- Mark to market is contrasted with historical cost accounting, which maintains an asset's value at the original purchase cost.
- In futures trading, accounts in a futures contract are marked to market on a daily basis. Profit and loss are calculated between the long and short positions.
Understanding Mark to Market (MTM)
Mark to Market in Accounting
Mark to market is an accounting practice that involves adjusting the value of an asset to reflect its value as determined by current market conditions. The market value is determined based on what a company would get for the asset if it was sold at that point in time. At the end of the fiscal year, a company's balance sheet must reflect the current market value of certain accounts. Other accounts will maintain their historical cost, which is the original purchase price of an asset.
For example, companies in the financial services industry may need to make adjustments to their asset accounts in the event that some borrowers default on their loans during the year. When these loans have been identified as bad debt, the lending company will need to mark down its assets to the fair value through the use of a contra asset account such as the "allowance for bad debts."
A company that offers discounts to its customers in order to collect quickly on its accounts receivables (AR) will have to mark its AR to a lower value through the use of a contra asset account. In this situation, the company would record a debit to accounts receivable and a credit to sales revenue for the full sales price. Then, using an estimate of the percentage of customers expected to take the discount, the company would record a debit to sales discount, a contra revenue account, and a credit to "allowance for sales discount," a contra asset account.
In personal accounting, the market value is the same as the replacement cost of an asset. For example, homeowner's insurance will list a replacement cost for the value of your home if there were ever a need to rebuild your home from scratch. This often differs from the price you originally paid for your home, which is its historical cost to you.
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. Mutual funds are also 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).
Example of Mark to Market (MTM)
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 margin account will be decreased and the short margin account increased to reflect the change in value of the derivative. Conversely, an increase in value results in a increase to the margin account holding the long position and a decrease 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, 2019. Since each contract represents 5,000 bushels, the farmer is hedging against a price decline on 50,000 bushels of wheat. If the price of one contract is $4.50 on November 21, 2019, the wheat farmer's account will be recorded as $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. The Cumulative Gain/Loss column shows the net change in the account since day 1.
Because the farmer has a short position in wheat futures, a fall in the value of the contract will result in an increase to his account. Likewise, an increase in value will result in a decrease to his account. 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 subtracted from the farmer's account balance, the exact amount will be added 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 expiration date of the futures contract or until the farmer closes out his position by going long on a contract with the same maturity.
Special Considerations and Recent History of Mark to Market (MTM)
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 the asset has low liquidity or investors are fearful, the current selling price of a bank's assets could be much lower than the actual value.
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.