Mark to Market Explained
Mark to market accounting and valuations are a key element of the financial system, and relevant to both traders and investors for slightly different reasons.
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If you are starting to learn about investing, you’ve probably seen the term mark to market pop up from time to time. Chances are, you’ve found the term confusing, because it’s used in different ways. Don’t worry, you are not alone — a lot of people find it confusing because it does have two different applications. ✌
Listed companies often report mark to market profits and losses, and this is something shareholders (and prospective shareholders) need to be aware of. At the same time, if you trade futures, or any derivative instruments for that matter, your futures broker will mark your positions to market each day. The concept is similar – but also slightly different.
In this article we will break down the idea behind mark to market accounting and why it’s important for investors and traders in different ways. We’ve also included some examples that show how mark to market valuations have played a role in major events ranging from the Global Financial Crisis to Elon Musk’s proposed acquisition of Twitter.
- What is Mark to Market?
- Understanding Mark to Market
- Alternatives to Mark to Market
- Mark to Market for a Futures Position
- Why is Mark to Market Important?
- Pros and Cons
- Mark to Market Examples
- Conclusion
- FAQs
- Get Started with a Stock Broker
What is Mark to Market (MTM) Exactly? 📚
Mark to market is a method of reflecting the value of assets in a portfolio or on a company’s balance sheet. The term mark to market actually has two slightly different applications, the first being accounting and the second being investments and portfolio management.
If assets, or liabilities, are recorded on a balance sheet or in a portfolio, there are lots of different ways they can be valued. The basic idea of marking an asset to market is that it should be valued at a price at which it could realistically be sold. The most objective way to do this is to use the last price at which the asset was traded.
Mark to market accounting is also known as fair value accounting or market value accounting. Alternative methods of valuing an asset include historical cost accounting and the default risk valuation method.
Making Sense of Mark to Market 👨🏫
For assets to be valued at the last price at which they were traded, there needs to be agreement on what the last price was. In practice, assets are typically valued at the closing price each day – this is the last price at which the instrument was traded during a trading session. If the instrument does not trade on a given day, the mid price between the bid and offer, or the bid price is used.
MTM in Accounting 📜
Balance sheets are one of the essential statements used in accounting, and are based on the current value of assets and liabilities. When you know the value of a company’s assets and liabilities you can calculate the equity (assets – liabilities) and decide whether the company is solvent. But, for a balance sheet to really be useful, the assets and liabilities need to be accurately valued.
Traditionally, assets were valued at their original cost, less depreciation. But this method doesn’t always give a true reflection of the real value of an asset, particularly when it’s an instrument that will need to be sold at some point. In this case, it’s more appropriate to value the asset at a price at which it can actually be sold. Hence, the assets value is marked at the current market price.
MTM in Investing 💰
In the world of investing, asset and portfolio values need to be up to date at all times. Brokers and fund managers need to be able to report accurate data to their clients, and to effectively manage risk. Investors also need to be able to calculate capital gains and losses for tax purposes.
Assets can only be marked to market if they are traded regularly. This means they need to be fungible – meaning one unit is the same as another unit. One share of Microsoft is the same as any other share of Microsoft, so the value of every Microsoft share can be based on the last price at which it traded. By contrast the value of a house isn’t necessarily the same as the last house that sold. Whenever possible, assets will be marked to market, and when it’s not possible another method will be used.
Which Assets Can and Can’t Be Marked to Market? 🗃
| Asset | Can it Be Marked to Market? |
|---|---|
| Shares Listed on Stock Exchanges | Yes |
| Shares That Are Traded on OTC (Ove-the-Counter) Markets | Yes |
| Bonds | Yes |
| Derivatives | Yes |
| Commodities | Yes |
| Currencies | Yes |
| Cryptocurrencies | Yes |
| Real Estate | No |
| Private Equity and Venture Capital Investments | No |
| Private Companies | No |
| Art and Antiques | No |
| NFTs (Non-Fungible Tokens) | No |
| Some Non-Standard Loans and Derivatives | No |
Futures Contracts and Other Derivatives 📃
Marking to market is an essential part of the daily settlement process for any instruments that are traded on margin. This includes derivatives like futures, options and CFDs (contracts for difference) and margin stock trading accounts. For any position traded on margin, the profit or loss needs to be settled each day to ensure that the holder actually has the capital to maintain the position.
We can use a simple example to illustrate why margined positions need to be marked to market and settled each day. Imagine a broker allows a client, we’ll call him Jim, to trade on margin with leverage of 4 to 1 and $5,000 in their trading account.
Jim invests in 20 shares of Tesla at $1,000 a share. Six months later when Jim sells the shares, they are trading at $500, so that means he has lost $10,000. The broker still has the $5,000 margin, but if Jim is unable to pay the remaining $5,000, the broker will be out of pocket.
To avoid this situation, the position is valued each day using MTM. If there is a profit, it will be credited to Jim’s account. But, if there is a loss, Jim will need to top up his margin account.If Jim cannot cover the daily loss, the broker closes the position and limits the potential loss for themselves and for Jim.
Stocks 📈
Stocks in any trading account or portfolio are also marked to market each day. Profits and losses don’t need to be settled each day like they do with margin instruments, but portfolios and positions do need to be valued each day for reporting purposes.
Any reputable trading platform or app will generally reflect the real time value of each position. Statements that are sent to clients reflect values based on monthly or quarterly closing prices.
MTM reporting is particularly important at month end and quarter end, and at the end of the tax year when capital gains tax is calculated. Management fees are calculated as a percentage of the MTM value of a portfolio at the end of each month. In cases where performance fees are paid, they are based on the change in the MTM portfolio value over a given period.
If a stock portfolio is used as collateral for a loan, the lender will also want to see regular MTM portfolio values. Margined stock trading accounts effectively provide investors with leverage by lending cash to the investors and using the value of the portfolio as collateral. The MTM process for a margin stock trading account is similar to the way futures positions are marked to market.
Mutual Funds and ETFs 🏢
Mark to market accounting is also essential for funds like mutual funds and exchange traded funds (ETFs). Each position in a fund needs to be accurately valued so that the NAV (net asset value) of the fund can be calculated each day.
If you invest in a mutual fund, the number of units you buy, and their price will be based on the NAV which is calculated at the same time each day. When you redeem your investment, the price is again based on the NAV.
The price of an ETFs varies throughout the day, but the NAV is used as a reference price. Typically the market bid price will be just below the NAV, while the ask price will be slightly higher than the NAV. The official NAV is calculated by marking the funds’ assets to market at the same time each day.
Alternatives to Mark to Market Accounting ♻
There are several alternatives to MTM valuation, and the best method varies according to the type of asset or liability being valued.
Historical cost accounting with depreciation is suitable for assets like machinery, vehicles and furniture. When it comes to assets that don’t necessarily depreciate, a valuation estimate from an independent expert or appraiser is more appropriate. This approach makes sense for real estate, art and antiques.
Placing a value on a private company is a subjective process and the estimate will vary depending on who you ask. Typically, a private equity or venture capital investor will use some sort of DCF (discount cash flow) model, DCF models take estimated future cash flows, discount them to account for the cost of capital and risk, and then add them up to arrive at a total value. This method is based on a lot of assumptions — from cash flows to interest rates — so it’s really an educated guess.
Mark to Market for a Futures Position 📄
Futures contracts are leveraged instruments that allow a trader to hold a long or short position several times larger than the amount (margin) they initially commit to a trade. The ratio between the initial margin and the exposure of a trade is the leverage. There’s also usually a multiplier used to calculate the value of one contract.
In this example, we will use corn futures which have a contract size of 5,000 bushels. So, if corn is trading at $7.50 a bushel, on contract it is worth $37,500. Now let’s assume your broker allows you to trade with leverage of 10 to 1. So, that means you can open a one contract position using $3,750 of margin.
If you open a short position at $7.50 and the price rises $0.50 to $8.00 on the first day, you have a mark to market loss. The MTM loss is equal to the change in the value of the contract, multiplied by the multiplier of 5000: $0.50 x 5,000 = $2,500. This amount will then be debited from your trading account.
After the first day, your mark to market profit or loss is calculated by multiplying the daily change in price by the multiplier. And, when you close the position, the MTM profit or loss is calculated by using the difference between the previous day’s closing price and the price at which the trade is closed — which is once again multiplied by the multiplier.
We have included a more detailed example of MTM for futures positions in a later section.
Why is Mark to Market Important? 🤔
When assets or liabilities can be valued using MTM methods, it gives potential stakeholders a realistic opinion of their value. This gives investors and lenders the ability to manage risk and liquidity. Ultimately, better risk management leads to more liquidity and lower borrowing costs within the financial system.
But there is also a drawback to the method as you will see below. When assets are marked to market, volatility can cause a chain reaction throughout the financial system, which can sometimes become a vicious cycle.
If you are trading with leverage, it’s also important to know how positions will be marked to market each day so that you can make sure you are not taking on too much risk.
Pros and Cons of Mark to Market ⚖
The use of MTM may be the best of the available methods to value liquid assets. However it is by no means perfect, and there are several pros and cons to MTM.
The closing price of liquid assets is usually readily available, and often available for free. This Makes it more cost effective than hiring professional third parties to value assets. If a data feed is used, the process can be automated, which eliminates the risk of human error.
Most of the alternative methods of valuing an asset are subjective and prone to bias. When subjective valuation methods are used, they can be manipulated to suit various parties. By contrast, it’s more difficult to manipulate the closing price of liquid assets like large cap stocks.
MTM valuation is an essential element of the trading process for margined instruments like derivatives, and allows brokers to manage their risk.
The use of MTM valuations can have unintended consequences for an economy. This was highlighted by the Great Financial Crisis of 2008 which resulted in instability in the financial system. If institutions are required to mark all their assets to market, they may be required to sell assets when prices are falling, which causes prices to fall further. This can create a vicious cycle of volatility.
Banks and institutions can also become technically insolvent when market price trade at irrationally low prices.
Investors often act irrationally when they see the value of their portfolio decline. People are more likely to panic sell the assets that are priced every day, than illiquid assets like real estate, art or collectables.
It’s difficult to manipulate the closing price of a large cap stock. But this isn’t always the case when it comes to small cap stocks with low liquidity. MTM valuation can only be used for instruments that are regularly traded. Other assets need to be valued using alternative methods.
Pros
- Cost Effective
- Can Be Automated
- Fairly Objective
- Difficult to Manipulate (In Most Cases)
- Essential for Derivatives
Cons
- Can Lead to Market Instability
- Can Result in Insolvency for Companies
- Psychological Impact on Investors
- Small-Cap Stock Prices Can Be Manipulated
- Can’t Be Used for All Assets
Mark to Market Examples 📝
The following three examples will give you an idea of how the market world works in the real world.
Elon Musk’s Proposed Acquisition of Twitter 🐦
In April 2022, Elon Musk launched a bid to acquire Twitter for $43 billion. While Musk was the richest person in the world, the bulk of his fortune was tied up in his share of Tesla. Rather than sell $43 billion in Tesla shares, he set out to fund part of the acquisition using $12.5 billion in loans. These loans would be backed by collateral consisting of Musk’s Tesla shares.
When lenders make a loan of this size, they need to ensure that the value of the collateral is maintained. They do this by marking the value of the collateral to market each day. If the value falls, Musk needs to make up the difference with cash by selling shares. While Musk owns 162 million shares, the bulk of these shares are ‘locked up’ and cannot be sold or pledged for five years.
This arrangement can lead to various knock-on effects and consequences. If Tesla’s stock price falls, Musk needs to sell shares, which puts more pressure on the share price, creating a vicious cycle. In addition, some of Tesla’s shareholders see this as a risk, and have sold more shares — placing even more pressure on the share price.
The 2008 Global Financial Crisis 🏦
Mark to market valuation methods contributed to the 2008 global financial crisis. Banks are required to maintain a balance between their assets and liabilities, which are both valued using market prices.
Because banks were legally required to value their assets using MTM accounting, they had to write down a large percentage of the assets they held. This left them with more liabilities than assets, and because there was so little liquidity in the market they couldn’t close positions. The result was that most banks were no longer able to either lend or borrow, and liquidity dried up even more.
This led to the Financial Accounting Standards Board relaxing some accounting rules in March 2009.
Marking a Futures Position to Market 🎯
We will use the S&P500 e-mini futures contract to illustrate the way mark to market accounting is used to settle the profit and loss for a futures position each day.
An e-mini futures contract is worth 50x the value of the index. The initial margin required to trade a contract is established by stock brokers — for this example we will say it’s 25%. Let’s say Sam has $50,000 in their trading account and wants to buy one contract.
He buys one contract at a price of 3,950, so its value or exposure is $197,500 (3,950 x $50). The initial margin on this position is $49,375 leaving just $625 in the traders account.
- ☑ Day 1: The futures close at 3,850, so when the position is marked to market it shows a $5,000 loss (100 x $5,000). Sam is therefore required to deposit at least $4,375 to maintain the position. If he can’t produce this amount, Sam’s broker will close the position and recoup the loss from the initial margin of $49,375.
- ☑ Day 2: The futures price rallies 300 points to close at 4,150. When the position is marked to market the position shows a profit of $15,000 (300 x $50) for the day. This amount is credited to Sam’s account.
- ☑ Day 3: The futures fall 50 points early in the trading session at which point Sam closes the position at 4,100. The daily profit is then calculated using the price at which the trade was closed, rather than the usual mark to market price. Sam’s account is credited with the initial margin of $49,375 minus the $ 2,500 loss for the day, leaving $61,875.
In this example, Sam started with $50,000 in his trading account, deposited an additional $4,375 and ended up with $61,875 — so the realized profit is $7,500. We can also calculate the profit by subtracting the opening price from the closing price (4,100 – 3950 = 150) and multiplying by $50 to arrive at $7,500.
By marking the position to market each day, the profit or loss can be settled daily to avoid a situation where the broker is left with a large loss. In this example, if the price fell below 3,160, the initial margin would no longer cover the loss.
Conclusion 🏁
The most realistic way to value assets is by valuing them at the last price at which they traded. But, there are several disadvantages, and the process can have implications for the entire financial system.
Mark to market is also an essential part of the process of trading and investing margin instruments like futures, and prevents small losses growing into losses that are disastrous for brokers and their clients.
Mark to Market: FAQs
-
How Does One Mark Assets to Market?
Assets can be marked to market by using the last price at which the asset was traded. Typically this will be the official closing price on an exchange.
-
Are All Assets Marked to Market?
No - only assets that are generic and regularly traded can be marked to market. Instruments like stocks and bonds can be marked to market, while real estate and art needs to be valued by an independent third party.
-
What Are Mark to Market Losses?
Mark to market losses are recorded when an asset is trading at a price that’s lower than the price at which it was purchased. A MTM only becomes a realized loss when it is sold.
-
What is MTM Profit?
A MTM profit is an unrealised profit. The asset is trading at a higher price than the price at which it was purchased. This profit is realized when the asset is sold.
-
What is Mark-to-Market in Investing?
Mark to market in investing is a process of valuing positions at the daily closing price each day. In the case of margined instruments like derivatives, the MTM profit or loss is settled each day.
-
What Does Daily Mark-to-Market Mean?
Daily mark to market is the process of valuing an asset at the official closing price for each trading day. This ensures that a portfolio reflects the most up to date price for each instrument.
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