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Tuesday, February 8, 2011

How mark-to-market valuation works

Mark-to-market, also called marking to market, is financial lingo for the settling of funds owed between brokers and/or or market exchange facilitators such as the Chicago Mercantile Exchange (CME) or Foreign Exchange (FOREX). This occurs when a financial instrument such as commodities futures contracts are purchased with borrowed funds fall below or rise above a certain mark also known as margin percentage.

In other words, when a pre-established market price for a financial instrument reaches a certain point outside a specified percentage range or minimum value of collateral, the terms of the exchange require return of funding to compensate for a corresponding decline or rise in the price of a security such as a stock options or futures contract.

Attributes of mark-to-market

Mark-to-market can sometimes refer to market valuation of financial instruments such as managed funds per Investopedia. However, this definition is separate from the traditional meaning of the term, and can serve to complicate the terminology otherwise defining market value of an asset. Some key aspects of the margin mark to market between brokers and as described above are as listed.

• Protects lender from a decline in collateral i.e. stock option
• Allows lender to acquire an additional capital if collateral value declines 
• Requires an increase to borrowers margin if collateral rises in value
• Similar to a margin call between an options trader and a broker
• Facilitates credit leveraging between broker & exchange 'clearinghouse'

Illustration of mark to market

To illustrate the concept of mark-to-market and its application in practice the following example can be demonstrative. Broker A wants funds to enable a leveraged investment requested by a client. Since Broker A's funds are limited it borrows funds from Broker B on margin i.e. on credit. This credit is collateralized by a percentage portion of the security/financial instrument that is being leveraged.

For example, Broker A's client buys 1000 lbs of coffee at a price of $3.00/lb or $3000.00. A 20 percent margin is required by the commodities exchange as collateral for the lent funds. If the price of coffee declines to $2.90 per lb, the contract is now valued at $2900.00 and the margin requirement falls short by $20.00. Marking to market means the $20.00 would have to be added to the account either through addition of funds or selling of approximately 6.89 lbs of coffee or another agreed upon asset. Similarly, if the price of coffee where to rise to $3.10/lb, the commodities exchange would add $20 in funds to the margin account to represent the 20 percent collateral.

Similarly, a mark-to-market may also be applied to FOREX and/or Stock options. For example, if Broker A's client borrows funds to sell 10 call options (100 shares each) of ABC company with a strike price of $20.00/share and the share price rises above the strike price, the seller of the call option will be obligated to pay the difference between the market value and the strike price upon exercising of the option.

Marking to market can occur before the exercising of the option to ensure adequate collateral exists to pay the difference between strike and market price. In other words, if shares of ABC company rise to $22.50 the difference between the strike price and the market price becomes $2250.00. If the original margin was 20% or $2000.00, $250.00 will have to be added to mark to market.

Advantages and disadvantages of mark-to-market

Marking to market serves as a control mechanism for fluctuations in market prices and is therefore a form of partially secured credit. In this sense mark-to-market helps ensure solvency for the lender of leveraged funds. However, in the case of margin marking to market between brokers and clients, extreme price volatility may lead to less broker solvency and insufficient funds if it only accounts for a pre-specified collateral percentage.

The process of marking to market is a price risk insurance aspect of the facilitation of liquidity within market exchanges be they commodities, financial or stock related. This control mechanism and the liquidity it represents enhances trading activity and availability of funds in a similar way to the way a market maker or specialist facilitates liquidity of trading instruments such as shares. In other words, mark to market is a form of price risk insurance.

In the case of derivatives such as credit derivatives or less readily calculable derivatives, the market price of the financial instrument may be obscure. Consequently, the process of marking to market makes misrepresentation, misinformation and misunderstanding a financial moral hazard. For this reason, being thoroughly familiar with the valuation of and price fluctuations of the financial instrument being marked helps ensure actual rather than estimated mark to market calculations.

Marking to market is traditionally a form of collateralizing assets for price movements within market exchanges. Marking to market is a financial adjustment between borrowers and lenders that takes place on a periodic rather than continual basis.

The process of marking to market is similar to margin calls between brokers and clients and helps insure the lender from credit risk. It is also an aspect of liquidity control by clearinghouses such as the Chicago Mercantile Exchange. In the case of little known derivatives with elaborate pricing calculations, marking to market may include the risk of fraud requiring extra diligence on the part of the borrower.

Text sources:

Eugene F. Brigham and Michael C. Ehrhardt. "Financial Management: Theory and Practice 10th Ed." Southwestern. 2002 p.420-422.
Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p277-281.
Zvi Bodei, Alex Kane and Alan J.Marcus. 'Investments' Mcraw-Hill Irwin. New York, 2002. P. 265-271