Mark-To-Market: Back To School

downloadGoing on with our “Back To School” series today, we are with a  new addition of MTM (MARK-TO-MARKET) to it.

Well, MTM (Mark-To-Market) or “Fair Value Accounting” refers to accounting for the “fair value” of an asset or liability based on the current market price. Mark to market aims to provide a realistic appraisal of an institution’s or company’s current financial situation. MTM is an accounting act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.

This is done most often in futures accounts to make sure that margin requirements are being met. If the current market value causes the margin account to fall below its required level, the trader will be faced with a margin call.

The practice of mark to market as an accounting practice first developed among traders on futures exchanges during the 20th century. It was not until the 1980s that the practice spread to major banks and corporations, and beginning during the 1990s, mark-to-market accounting began to result in scandals. MTM/Fair value accounting has been a part of Generally Accepted Accounting Principles (GAAP) in the United States since the early 1990s, and is now regarded as the “gold standard” in some circles.

Mark-to-market accounting can change values on the balance sheet as market conditions change. Mark-to-market accounting can become inaccurate if market prices fluctuate greatly or change unpredictably. Buyers and sellers may claim a number of specific instances when this is the case, including inability to value the future income and expenses both accurately and collectively, often due to unreliable information, or over-optimistic or over-pessimistic expectations. In marking-to-market a derivatives account, at pre-determined periodic intervals, each counterparty exchanges the change in the market value of their account in cash. For Over-The-Counter (OTC) derivatives, when one counterparty defaults, the sequence of events that follows is governed by an ISDA contract. For exchange traded derivatives, if one of the counterparties defaults in this periodic exchange, that counterparty’s account is immediately closed by the exchange and the clearing house is substituted for that counterparty’s account. Marking-to-market virtually eliminates credit risk, but it requires the use of monitoring systems that usually only large institutions can afford. Stock brokers allow their clients to access credit via margin accounts. These accounts allow clients to borrow funds to buy securities. Therefore, the amount of funds available is more than the value of cash. The credit is provided by charging a rate of interest, in a similar way as banks provide loans. Even though the value of securities fluctuates in the market, the value of accounts is not computed in real-time. Marking-to-market is performed typically at the end of the trading day, and if the account value decreases below a given threshold, the broker issues a margin call that requires the client to deposit more funds or liquidate his account.

Mutual funds are marked to market on a daily basis at the market close so that investors have an idea of the fund’s NAV.

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