Mark-to-Market

Mark-to-market is the practice of valuing an asset, liability or open trading position at its current market price instead of the price originally paid. In trading, positions are marked at the end of every day, and the gains or losses are settled in cash. In accounting, it is part of fair value measurement, under which some balance sheet items are restated each reporting period.

The opposite approach is historical cost accounting, in which an asset stays on the books at its purchase price until it is sold or written down. Mark-to-market is sometimes called fair value accounting, although fair value is the broader idea: when no market price exists, it is estimated with models, a practice nicknamed "mark-to-model". In the United States the rules are set by the Financial Accounting Standards Board (FASB) in ASC 820; most other countries follow IFRS 13.

Suppose you bought a house ten years ago. Ask what it is worth and you could give two answers: the price you paid, or what similar houses on your street are selling for this month. Marking to market means always giving the second answer, even if you have no plan to sell.

That keeps the picture honest when prices rise or fall, because nobody can pretend an asset is worth more than buyers would pay today. The catch is that the answer changes all the time, and if there are few recent sales on the street, someone has to make an educated guess. Two honest valuers can then reach different numbers for the same house, and a dishonest one can pick whichever number suits them best.

On futures exchanges, every open position is revalued daily at an official settlement price. The change in value is paid between the two sides as variation margin, collected and distributed by a central counterparty. The daily gain or loss on a position is:

• $Q$ is the number of contracts or units held; it is negative for a short position.
• $M$ is the contract multiplier, the value of a one-point price move.
• $P_{\text{today}}$ and $P_{\text{yesterday}}$ are the latest and previous settlement prices.

For example, a trader long 5 stock index futures contracts with a multiplier of 50 dollars sees the settlement price rise from 5,000 to 5,040. The position gains $5 \times 50 \times 40 = 10{,}000$ dollars, credited that evening. If the price later falls, losses are debited the same way, and a shortfall can lead to a margin call or forced liquidation. Bilateral OTC derivatives are marked in a similar way, often using dealer quotes or valuation models, and the result determines the collateral exchanged.

FASB issued Statement 157 on fair value measurement in September 2006, now codified as ASC 820, and the International Accounting Standards Board published IFRS 13 in May 2011, effective from 2013. Both define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants, and both rank inputs in three levels:

• Level 1. Quoted prices for identical items in active markets, such as a listed share.
• Level 2. Observable inputs other than quoted prices, such as prices of similar instruments or market yield curves.
• Level 3. Unobservable inputs based on the reporting firm's own assumptions, used for illiquid holdings.

Trading securities and derivatives are generally carried at fair value, while many loans held to maturity are not. Firms that use derivatives to offset other risks may apply hedge accounting so that both sides of the hedge reach earnings at the same time. In US tax law, Section 1256 of the Internal Revenue Code treats regulated futures contracts as if sold at their market value at the end of each tax year.

The Enron case is the best-known misuse. In January 1992 the SEC accepted Enron's use of mark-to-market accounting for its natural gas trading business, and the company later applied it to long-term energy contracts with no active market, booking estimated lifetime profits up front from its own models. When those estimates and related off-balance-sheet structures unravelled, Enron filed for bankruptcy in December 2001.

During the 2008 financial crisis, banks argued that marking illiquid mortgage securities to fire-sale prices exaggerated losses and drained regulatory capital, deepening the crisis. Supporters replied that hiding losses would have delayed recognition, as in the savings and loan crisis. The Emergency Economic Stabilization Act of 2008 ordered an SEC study, which recommended against suspending fair value, and FASB issued guidance in April 2009 on valuing assets in inactive markets.

Mark-to-market works best when markets are deep and prices are reliable. For thinly traded holdings, values depend heavily on models and judgement, which can be manipulated or simply wrong. It can also make reported earnings volatile, and in falling markets it can force sales that push prices lower still, a pattern that weighs most heavily when liquidity dries up.

• IFRS Foundation: IFRS 13 Fair Value Measurement
• Financial Accounting Standards Board