Marking to Market Meaning

Marking to Market (MTM) means valuing the security at the current trading price. Therefore, it results in the traders’ daily settlement of profits and losses due to the changes in its market value.

  • Suppose on a particular trading day, the value of the security rises. In that case, the trader taking a long position (buyer) will collect the money equal to the security’s change in value from the trader holding the short position (seller).On the other hand, if the security value falls, the selling trader will collect money from the buyer. The money is equal to the change in the value of the security. It should be noted that the value at maturityValue At MaturityMaturity value is the amount to be received on the due date or on the maturity of instrument/security that the investor holds over time. It is calculated by multiplying the principal amount to the compounding interest, further calculated by one plus rate of interest to the period’s power.read more does not change much. However, the parties involved in the contract pay gains and losses to each other at the end of every trading day.

Steps to Calculate Mark to Market in Futures

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Marking to Market (wallstreetmojo.com)

Example of Marking to Market Calculations in Futures

Example #1

Let’s assume two parties are entering into a futures contract involving 30 bales of cotton at $150 per bale with a 6-month maturity. It takes the value of security to $4,500 [30*150]. At the end of the next trading day, the price per bale increased to $155. The trader in a long position will collect $150 from a trader in a short position [$155 – $150] * 30 bales for this particular day.

  • Determining Settlement Price Various assets will have different ways of determining the settlement price, but generally, it will involve averaging a few traded prices for the day. Within this, the last few transactions of the day are considered since it accounts for considerable activities of the day.The closing price is not considered as it can be manipulated by unscrupulous traders to drift the prices in a particular direction. The average price helps in reducing the probability of such manipulations. Realization of the Profit/Loss The realization of profit and loss depends on the average price taken as the settlement price and pre-agreed upon contract price.

Various assets will have different ways of determining the settlement price, but generally, it will involve averaging a few traded prices for the day. Within this, the last few transactions of the day are considered since it accounts for considerable activities of the day.The closing price is not considered as it can be manipulated by unscrupulous traders to drift the prices in a particular direction. The average price helps in reducing the probability of such manipulations.

The realization of profit and loss depends on the average price taken as the settlement price and pre-agreed upon contract price.

On the flip side, if the mark to the market price for every bale falls to $145, this difference of $150 would be collected by the trader in a short position from the trader in the long positionLong PositionLong position denotes buying of a stock, currency or commodity in the hope that the future price will get higher from the present price. The security can be bought in the cash market or in the derivative market. The course of action suggests that the investor or the trader is expecting an upward movement of the stock from is prevailing levels.read more for that particular day.

From the perspective of maintaining the books of accounts, all gains would be considered ‘Other Comprehensive IncomeOther Comprehensive IncomeOther comprehensive income refers to income, expenses, revenue, or loss not being realized while preparing the company’s financial statements during an accounting period. Thus, it is excluded and shown after the net income.read more’ under the Equity section of the Balance Sheet. On the assets side of the Balance sheet, the account of marketable securitiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company’s balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it.read more will also increase by the same amount.

The losses will be recorded as ‘Unrealized Loss’ on the income statementUnrealized Loss’ On The Income StatementUnrealized Gains or Losses refer to the increase or decrease respectively in the paper value of the company’s different assets, even when these assets are not yet sold. Once the assets are sold, the company realizes the gains or losses resulting from such disposal.read more. Therefore, the marketable securities account would also decrease by that amount.

Example #2

Let us consider an instance whereby a farmer growing apples is in anticipation of the commodity prices to rise. Therefore, the farmer considers taking a long position in 20 apple contracts on July 21. Further, assuming each contract represents 100 bushels, the farmer is heading against a price rise of 2,000 bushels of apple [20*1,000].

Say, if the mark to the market price of one contract is $6.00 on July 21, the farmer’s account will be credited by $6.00 * 2,000 bushels = $12,000. Now depending on the change in price every day, the farmer would either make a gain or loss basis the initial amount of $12,000. The below table would be helpful.

(in $)

Whereby:

Change in value = Future Price of Current Day – Price as of Prior Day

Gain/loss = Change in Value * Total quantity involved [2,000 bushels in this case]

Cumulative Gain/Loss = Gain/Loss of the current day – Gain/Loss of Prior Day

Account Balance = Existing Balance +/- Cumulative Gain/Loss.

Since the farmer is holding a long position in the apple futures, any increase in the value of the contract would be a credit amount in their account.

Similarly, a decrease in the value will result in a debit. It can be observed that on Day 3, apple futures fell by $0.03 [$6.12 – $6.15], resulting in a loss of $0.03 * 2,000 = $60. While this amount is debited from the farmer’s account, the exact amount would be credited to the account of the trader on the other end. This person would be holding a short positionShort PositionA short position is a practice where the investors sell stocks that they don’t own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more on wheat futures. This theory becomes a gain for one party and a loss for another.

Benefits of Marking to Market in Futures Contract

  • Daily marketing to the market reduces counterparty riskCounterparty RiskCounterparty risk refers to the risk of potential expected losses for one counterparty as a result of another counterparty defaulting on or before the maturity of the derivative contract.read more for investors in Futures contracts. This settlement takes place until the contract expires.Reduces administrative overheadAdministrative OverheadAdministrative overheads are expenses that are not directly linked to the production & distribution of goods & services but are indirect in nature, such as expenses incurred in the policy formulation, employee cost, legal and audit fees, telephone and electricity expenses.read more for the exchange;It ensures that when the daily settlements have been made at the end of any trading day, there will not be any outstanding obligations, which indirectly reduce credit risk.

Drawbacks of Mark to Market in Futures

  • It requires continuous monitoring systems, which are very costly and can be afforded only by large institutions.It can cause concern during uncertainty as the value of assets can swing dramatically due to the unpredictable entry and exit of buyers and sellers.

Conclusion

The purpose of marking market prices is to ensure that all margin accounts are kept funded. Therefore, if the mark to market price is lower than the purchase price, i.e., the holder of a future is making a loss, the account has topped up with a minimum/proportionate level. This amount is called the Variation margin. It also ensures that only genuine investors are participating in the overall activities.

Credit has to be made in the margin account if a holder makes a profit. The ultimate purpose is to ensure that the exchange, which bears the risk of guaranteeing the trades, is firmly protected.

It should also be noted that if the holder of futures makes a loss and cannot top-up the margin account, the exchange will “close the member out” by taking an offsetting contract. The quantum of loss is deducted from the client’s margin account balance, and the balance payment is made out.

This article has been a guide to marketing and its meaning. Here we discuss examples of calculating mark to market in a futures contract and its advantages, benefits, and drawbacks. You can learn more about Financing from the following articles –

  • Cash Settlement vs. Physical SettlementDerivatives in FinanceExercise Price MeaningMark to Market Accounting