Mark to Market Explained - Get to Know Its Importance - YouTube

Greetings traders and welcome back to another Survival Guide.

Chris here, bringing you some more information.

Today, we're going to talk about what it means to mark something to market.

It is a process by which all of us as retail traders experience

at one point or another, so it's important understand what in the world it is.

This is something that will add to your bank of knowledge.

It may not be a technical analysis indicator, but the more

knowledge you have, the better the chance you have at passing

the Gauntlet Mini so listen up. If you liked the video guys,

please do me a favor and click that like and subscribe button

down below because it allows me to keep coming out with this

educational content for all of you out there.

But without further ado, let's get going folks.

The turbulent and volatile markets that we as traders navigate

today present us with lots of different challenges. Among

them, the main ones tend to be increasing the complexity

of ensuring a fair representation of our portfolio's value.

So is the case with the pricing of separate constituents

including shares, futures contracts, and other securities on

the market side of things. To overcome this, the financial

world has adopted what is called a mark to market methodology.

This is also known as "MTM." We're going to talk about how marking

to market affects us as retail traders, as well as the institutional

derivative traders. By the definition, mark to market is a method of measuring

values subject to periodic fluctuations to provide a fair

representation of the current state of the asset or entity.

Today, mark to market is used in investing, which means

stocks, futures contracts, mutual funds, accounting assets, and

liabilities, the list goes on and on. In trading, it is used

to better reflect a security account or a portfolio's current

market value instead of its book value. To do that,

it adjusts the value of the instrument or the account to

the current volatility and market performance.

The goal is to provide a fairer representation of the portfolio's

health. For example, if the recent market developments drag

the account below the required level, the trader receives

a margin call. In the context of mutual funds, mark to market

is used on a daily basis to help provide a better idea of

the fund's net asset value. For accounting purposes, mark to market

helps present a more transparent representation of

the current value of the company's assets and liabilities

based on today's market conditions.

The mark to market methodology was first introduced in the

1800's in the United States. At the time,

it was the usual practice of bookkeepers to use a mark to market strategy.

However, after a while, many started attributing the prerequisites

for the Great Depression, the instability of the economic

system, as well as the bank's mass collapse due to the mark

to market strategy. In 1938, its use was discontinued. But in

the 1980's, it was reintroduced. This time it wasn't a smooth ride.

Growing popularity of the methodology also exposed its loopholes.

As many corporations and banks started applying mark to market over time,

they found weaknesses in its design that could be exploited

for accounting frauds. Mainly in situations where the real

day-to-day asset value couldn't be determined objectively,

like in the case of crude oil futures, where the price of

the instrument is derived from another commodity.The epitome

of a wrongful application of mark to market accounting principles,

for example, was the biggest scandal in corporate history.

The fall of Enron. After that case, regulators introduced changes

in the mark to market method, including implementing stricter

accounting standards, more explicit financial reporting, independent

auditing, and more robust internal controls in an attempt

to make the mark to market more digestible and more enforceable.

Today, mark to market is an officially recognized and widely

adopted methodology for tracking the fair and actual value

of accounts and an entity or individual's current financial

situation. You might be wondering if there is so much difficulty

behind making sure mark to market works properly,

well, what is the need behind it? The need for a method

like mark to market is mainly to prevent market manipulations

from happening. Alternatively,

it's used to ensure maximum transparency by representing

fairly the real value of an asset or account, or the financial

situation of a company at any point in time.

If we go back a few steps, we could say that the main issue

with market information is its relevance. Market participants often rely

on outdated and historical data to make evaluations or predictions

for the current or for a future period. During times with

high volatility or market dynamics

like the ones that we've been going through the last two

decades, it is crucial that the information is adequate and

fresh. That is why mark to market was introduced as an alternative

to the popular historical cost accounting methodology upon

which the asset's value was based on its original purchase cost. Understandably,

this type of evaluation can provide a fair representation

of the subject's current state. Alternatively,

it can't accurately calculate what it costs today because

the information is outdated and irrelevant to the current market environment.

However, if we focus on just one particular reason why mark to

market is needed, let it be this; To prevent the accumulation

of excessive risk for the specific entity, trading account,

or portfolio. Once again, that is to prevent the accumulation

of excessive risk for the specific entity, trading account,

or portfolio. By having access to fair and accurate information

about the state of an asset or an entity, market participants

can better predict its future trajectory.

Mark to market works differently based on its use case,

so let's talk about a few different examples. In the financial

industry, there is always the default risk. Once a default

occurs, the loan must be classified as a non-performing asset or as bad debt.

The company has to establish a separate account that marks

down the value of its assets. Mark to market helps do that

fairly and accurately. In the context of companies selling

goods and offering promotions or discounts, to collect accounts'

receivable quickly, the mark to market is required to record both a credit to

the sales revenue and debit to the account's receivables.

The values are based on the estimated number of customers

likely to take advantage of the discount. In personal accounting

practices, the market value of an asset is considered equal

to its replacement cost. For example, the insurance on your

home or vehicle usually includes the value it would need

to be rebuilt or repaired. When it comes to securities, the

mark to market methodology requires

fair value instead of book value.

For example, the stocks in your brokerage account are

marked to market at the end of each day.

The case is quite similar to futures contracts and mutual

funds where the value is calculated with the closing bell.

Let's assume that you, watching this video right now, is a

futures trader and you are going through the process of making

your first deposit with your preferred exchange.

The deposited funds are used as a margin or a protection

for the exchange against potential losses. Think of the margin

as a threshold that you should not fall below. At the end

of each day, with exchanges like the CME, which does it even

twice per day, the futures contracts in your portfolio are

marked to their present market value, which is called mark

to market. If the market developments were favorable, you

would be on the winning side.

Thus, your account's value would increase as the exchange pays

you the profits. On the other hand, if your futures contracts

have dropped in value, you would be suffering losses and

the exchange would be charging your account with the deposited margin.

If the loss is severe and your account's value dives below

the minimum margin requirement,

you will receive a margin call.

The margin call is the exchange urging you to deposit additional

funds to cover the minimum capital requirement,

otherwise you default. With this graph, this shows a practical

example of how mark to market is applied within futures contracts.

As with any other instrument, trading futures contracts requires two sides.

It requires a buyer and a seller. If the price of the contract

goes up at the end of the day, the buyer's account value increases

while the one of the short account decreases and vice versa.

Let's say that you are interested in trading wheat and

you want to hedge against falling prices of the underlying

commodity. You decide to sell 5 contracts, where one contract

equals 5,000 bushels. The current price, we'll say, is four

dollars. The trade will be equal to, then $100,000, as it is

opened. As you can see, each fall in the value of the wheat

futures contract results in an increase in your account balance

and vice versa when it goes the other way. The mark to market

calculation process continues until the expiration date of

the futures contract, or until you decide to close your

position. But futures trading doesn't only happen on traditional

exchanges. Institutions and large-scale investors prefer trading derivatives OTC.

This is over the counter. However, the case with over the counter derivatives trading

is a little bit more complicated. On these markets, the price

isn't regulated by the trading venue, but it's instead negotiated

between the buyers and sellers. What that means, is you can't

objectively determine or get the market price immediately.

Besides, the price should also include quantification of

default, which is also known as non-performance risk. To better

navigate this type of market, participants

usually use sophisticated computer models that can provide

relative pricing information that more often than not is

close to the price that they will ultimately be paying in

the end. In a nutshell, with futures trading, mark to market

is used to eliminate the credit risk.

However, to be applied adequately,

it requires the involvement of exchanges or institutional

investors trading OTC, since only they can afford the use of the

necessary sophisticated monitoring systems.

Like any other metric or methodology in the financial world,

marking to market isn't flawless. While it helps overcome

some issues, it does fall short on some other areas.

Let's first cover the advantages. On the pro side of things,

marking to market reflects the actual value of an asset. The

value for the asset is based on the current market environment,

which makes it genuine and a good representation of what's going on.

It doesn't rely on history or any data that might not be relevant to the current

situation and factors that might affect the value of the

account or assets. Another positive side of marking to market

is it reduces the levels of risk within the portfolio or

the entity. Mark to market can serve as a real-time warning

system for default or insolvency risk.

It can alert whether the current state of the company's portfolio is good enough

to justify investments or predict future performance and

exposure to unfavorable market conditions. Another pro

is the fact that it's beneficial for every side that is adopting

it, Mark to market brings advantages on a micro and a macro

level. Brokers, for example, can keep track of account balances

of their clients and prevent defaults. On the other hand, investors

can take advantage of margin trading, which is way easier

to monitor and control than before introducing the mark to market

methodology. With banks, businesses selling goods, financial

organizations, auditors and regulators, the mark to market methodology

provides a unified procedure to keep track of the current

state of the entities and their financial health that they're

currently adopting or currently trading.

On the other side of the coin, some cons that we should be aware of.

The first one is going to be that it can be inaccurate during

volatile periods. Volatility tends to throw pricing mechanics

out of bounds. The bigger and more fluctuations, the more distorted

and unstable the portfolio or the price of an asset's value is, the more unreliable

it can be. Another con is that it can't contextualize information.

Although this isn't necessarily a substantial disadvantage,

the truth is, mark to market can't tell how the price at the

closing bell was formed.

For example, it fails to reveal whether there was a significant

and sudden influx of buyers and sellers, and what changes

in that short period of time throughout the trading session

is something that is going to be hard for the mark to market

to ever differentiate, and it really can't. It has a difficult

time contextualizing the information as it finally closes

off. Then finally, another con could be that the momentum

dependency that can harm valuations during economic distress

is something that can be attributed to the mark to market

methodology. Companies that are forced to calculate selling

prices for their assets, like banks with bad loans triggering

insolvency procedures for example, during these economic

downturns, or low liquidity, or market uncertainty periods

where they might expect unfavorable valuations,

this can make it a bit more difficult during these situations.

In summary, mark to market is something that is meant to

solve problems that existed before the mark to market methodology.

It's not anything that's going to be considered completely

air tight and completely perfect.

However, the general consensus is that we are much better

off on both sides of the coin, meaning both retail as well

as institutional traders, with the mark to market methodology

in place than we are without it.

It doesn't mean that it'll be around forever because if ultimately,

someone does come up with an idea that is better in every

single way than mark to market,

well then I'm sure it will be adopted.

But until then, at least now you know exactly what mark to

market is, where it came from, and how it works. Until next

time folks, I wish you the best of luck in the markets.

Happy trading, happy hunting. I will see you soon, over and out.