What is Mark to Market (MTM)?

MTM has always played an important role in modern finance, especially in calculating the immediate value of assets and liabilities. The method’s effects penetrate even businesses’ reports regarding the performance of financial activities from the profit-and-loss account to investments.

During unstable periods of the markets, it will help an investor or firm to maintain its book position in light of prevailing market conditions and not historical costs. The result can bring volatility in the financial report, especially when the market becomes unstable. Understanding the impact of MTM becomes crucial in addressing risk and making rational financial decisions.

How does margin work in trading?

Margin trading is a type of investing style that involves buying stocks that are expensive and over your current budget. Through margin, you can buy stocks by paying only a small percentage of their prices, and the rest is provided by the stockbroker.

This margin amount is then paid with interest back to the broker. Until then, the broker holds the securities as collateral. If the profit you earn through the sale of the stocks is higher than the margin amount, you earn a profit. If not, you incur losses after settling the margin amount and squaring off the stock positions. You can manage these processes efficiently using an online trading app.

Types of Margin

There are two types of Margins charged by brokers:

• SPAN Margin: It is the basic required margin blocked by a stockbroker for Futures and Options contracts. It is calculated through the Value at Risk (VAR) method.
• Exposure Margin: This type of margin is blocked by the stockbrokers over and above the SPAN Margin to settle any MTM losses.

MTM Meaning

In financial terms, MTM or Mark to Market refers to the value of any asset as the current fair value after price or value fluctuations. Mark to Market is a method that aims to determine the real and fair value of a company’s financial situation based on the current market situation that is affecting the company’s performance. For example, if a bank or a financial company has realized losses because of bad loans, the total bad loans amount is adjusted in the balance sheet to determine the current fair value of the business. Hence, it is called Mark to Market.

However, the same term Mark to Market or MTM becomes Mark to Margin in the investing spectrum but is still widely referred to as Mark to Market. MTM in the investing market refers to the settlement of the daily gains and losses based on the price changes in the market value of the asset. Mark to Market is majorly used in the trading of Futures Contracts. If the value of the underlying asset goes down in a day, the seller of the contract collects money from the buyer. In case the price of the underlying asset goes up, the buyer collects money from the seller of the contract. This settlement is called MTM or Mark to Market and is done daily.

Understanding the nuances of Mark to Margin (MTM)

The prices of the futures contract fluctuate daily and can result in profit and losses for the buyers or the sellers. The MTM or Mark to Market settles these profits and losses daily by adjusting the initial margin (SPAN Margin + Exposure Margin).

Here is a detailed example to understand how MTM or the Mark to Market works in a Futures contract:

Suppose you buy the Futures of ABC company at Rs 150 with a lot size of 1,000 and square off your position after 3 days. The closing prices for 3 days are listed below:

Day 1: Rs 155
Day 2: Rs 160
Day 3: Rs 158

Without MTM or Mark to Market, you would have gained Rs 8,000 (158-150=8×1,000) after the end of three days. However, because of MTM or Mark to Market, the profit and losses are settled daily.

When you purchased the Futures contract, the price was Rs 150. But on Day 1, the price rose to Rs 155. In this case, your profit would be Rs 5,000 (155-150=5×1,000). This amount is credited to your trading account on Day 1 after the daily settlement.

The amount of profit, i.e. Rs 5,000 is debited from the seller’s trading account. The amount is withdrawn from the initial margin amount that the stockbroker blocks when getting into the trade. From Day 1 onwards, the price of the Futures Contract is treated as Rs 155, as the Rs 5 difference for 1,0000 shares has already been credited to your trading account. For Day 2, you will again receive Rs 5,000 as the price rose 5 points to Rs 160. However, for Day 3, your Margin account will be debited by Rs 2,000 as the price decreased from Rs 160 to Rs 158. This amount of Rs 2,000 will be credited to the trading amount of the seller.

How does the Margin call occur?

Now that you know what is MTM in trading, what happens if you are obliged to pay a certain amount and your margin amount falls short? That is when the Margin call occurs. A margin call is made when the initial margin balance falls below the maintenance margin. That is the point, the broker will make a margin call to the client to top up the trading account with more margins to avoid unnecessary risk. If the client does not bring in the additional margins on the margin call, the broker is at liberty to dispose of the position in the market to recoup their loss.

In simple words, you will have to provide the balance money needed to give to the other party in case the price of the futures contract declines before the daily settlement. Once you provide the balance margin amount to the stockbroker, you can move ahead with your positions and square off according to your preference.

Advantages & Disadvantages of MTM

While it offers several advantages, such as enhanced transparency and risk management, it also introduces certain challenges. Understanding MTM’s benefits and drawbacks is essential for assessing its impact on financial reporting, investment decisions, and market stability.

Pros:

• Real-Time Representation of the Market: MTM depicts the real-time worth of an asset, reflecting the real picture in financial statements, with a reflection on the prevailing market condition. This becomes especially important when the assets can change market prices quickly. It thereby provides an authentic presentation of financial health.
• Transparency and Relevance: MTM enhances transparency because the values of assets and liabilities are always tied to current market prices. This makes the financial reports even more relevant to investors, analysts, and regulators. They can base their decisions on the best information available to them.
• Risk Management Enhancement: MTM helps businesses identify risks quickly by constantly revaluing assets and liabilities. If the value of an asset in particular declines, then companies can immediately reduce exposures or amend hedging strategies to minimise the impact of loss.
• Better Decision-Making: Since MTM provides a current market value, management can make decisions based on the most accurate financial data. This can help companies optimise their portfolios, allocate capital efficiently, and adjust operations based on the prevailing market environment.
• Investor Confidence: MTM helps investors get a time-sensitive view of a company’s accounts, thereby building trust and reliability in the financial report’s integrity. This transparency can make companies more attractive to investors looking for accurate and timely financial data.

Cons:

• Volatility and Fluctuations: The biggest disadvantage of MTM is that it introduces volatility in financial statements. Market conditions may cause assets to fluctuate in value, which can cause large swings in reported earnings and balance sheets. This might not represent the company’s underlying performance or long-term prospects.
• Potential for Misleading Information: In times of market turbulence, MTM can misrepresent the true value of assets, especially when markets are irrational or illiquid. For instance, during a market crash, MTM may reflect a sharp decline in asset values even though the assets have long-term value or are not for sale. This may cause investors to overreact and make uninformed decisions.
• Inability to Value Illiquid Assets: MTM is highly dependent on observable market prices, which can be an issue in illiquid or unique assets such as private equity investments, real estate, or complex derivatives. Determining the fair market value of such items is difficult. Corresponding estimates are often subjective or highly volatile, which might lead to incorrect financial reporting.
• Short-term Emphasis: MTM encourages a short-term focus on market prices rather than long-term value. This makes companies and investors pay too much attention to market movements, causing them to miss the fundamentals of assets or the company’s long-term strategy.
• Regulatory and Accounting Challenges: A consistent application of MTM can be quite complicated, and demands repeated valuation updates, thereby increasing the administrative burden for companies and regulators. Sometimes, MTM may not be aligned with traditional accounting practices, leading to confusion and inconsistencies in financial reporting.
• Impact on Financial Stability: MTM has beencriticisedd for contributing to financial instability, especially in crises. Marking assets to market during a downturn can cause widespread writedowns that reduce the capital base of financial institutions, potentially exacerbating financial crises by triggering panic or forced asset sales.

Examples of Mark to Market

Let’s take the example of a cotton farmer in India who takes a short position in cotton futures contracts to hedge against a probable fall in cotton prices. Each futures contract represents 10,000 kilograms of cotton, and the farmer is hedging against a price fall on 100,000 kilograms of cotton.

Assumptions:

• The farmer goes short on 10 cotton futures contracts on 10 December.
• The value for one contract on 10 December is ₹ 40 per kg of cotton.
• The futures contract is for 10,000 kg. Therefore, the total value of this position on 10 December is ₹40 x 100,000 kg = ₹4,000,000.

Day-by-Day Example of Mark to Market:

Explanation:

• Day 1: The farmer enters a short position in 10 cotton futures contracts at ₹40 per kg. The total value is ₹4,000,000 (₹40 x 100,000 kg).
• Day 2: The price of cotton futures rises to ₹40.50. Because the farmer is short, a rise in price means a loss. Loss for the day is ₹0.50 x 100,000 kg = ₹50,000. This amount is debited from the farmer’s account and credited to the long-position trader’s account.
• Day 3: The price decreases to ₹40.30. In this case, the farmer earns ₹0.20 x 100,000 kg = ₹20,000, credited to the farmer’s account balance.
• Day 4: The price decreased to ₹39.80. In this case, the farmer gains ₹0.50 x 100,000 kg = ₹50,000, and the cumulative gain up to this point is ₹20,000.
• Day 5: The price was reduced to ₹39.50. The farmer is making ₹0.30 x 100,000 kg = ₹30,000. This amount sums up to ₹50,000, and the remaining balance will be ₹4,050,000.

The daily mark-to-market adjustments reflect changes in market prices. Each day, the gain or loss is settled by transferring the corresponding amounts between the accounts of the long and short position holders. The process continues until the contract expires or until the position is closed by reversing the trade.

Conclusion

MTM or Mark to Market is a great way to avoid trading risks. As the profits and losses are settled daily, you are at a lesser risk of wiping out the profits you earned one day because of the losses you incur on the next. As you realize profits, if any, daily, you know where you stand and can square off your positions as soon as your investing goals are achieved. This also allows you to manage your risk profile as after incurring certain losses, you can identify an exit point and ensure you do not incur further losses.