Banks in India are mandated to mark their investments to prevailing market prices and charge the gains or losses to the profit and loss account, also known as mark to market gains or losses. You will also find mark to market concepts in future contracts.
In this article, you will learn what is Mark to Market losses and Gains and how its used.
Mark to market losses or gains occur when a financial instrument is valued at its current market price. If the financial security was purchased at a higher price than the current market price, then the holder would have an unrealised loss.
As a result, marking the security down to the current market price will result in mark to market loss.
If the market value of the security is above its buying price, then the unrealised gain will result in mark to market gain.
It’s the concept of fair value accounting which gives a more transparent picture of the value of a company’s assets.
Remember, mark to market gains or losses are generated through accounting entry rather than the actual sale of a security.
Given the changing market conditions companies are required to revalue their financial securities under current market conditions. Mark to market losses shows the current financial conditions within the backdrop of present market conditions.
In historical cost accounting, assets are recorded at original cost to calculate its valuation.
When asset price decreases since the original purchase, the company needs to record a mark to market loss.
Fair value of an asset is the price that the company would have received by selling an asset to market participants at the measurement date.
Mark to market losses will have an adverse impact on the company’s RoA (return on asset) and RoE (Return on equity).
Mark to market concept in future contracts
Markt to market (MTM) is used in future contracts for daily settlement of profit and losses arising due to the change in the security’s market price until it is held.
MTM is a method in which underlying assets’ fair value is determined based on the current market situation. It refers to the settlement of daily gain or losses based on the price changes in the market value of the asset.
Gain and losses on a daily basis are adjusted to the initial margin.
For future contracts, Mark to market (MTM) calculation is done after trading hours. Closing price of the day is considered for calculation.
Mark to market (MTM) is not calculated for options or equity stocks.
If you are in loss and don’t have sufficient balance in your account, then the position might be squared off by the broker with a levy of margin penalty.
In future contracts, if the value of the underlying securities goes down in a day, then the seller of the contract collects money from the buyer.
Instead, if the price of the underlying securities goes up, the buyer collects money from the seller of the contract. This settlement is called mark to market (MTM) and is done daily.
Example to understand how Mark to Market (MTM) works in future contracts
Suppose you bought futures of XYZ limited at Rs 200 with a lot size of 500 and square off your position after 3 days at Rs 210.
Here are the closing prices of XYZ limited;
- Day 1 closing price: Rs 205
- Day 2 closing price: Rs 210
- Day 3 closing price: Rs 208
Without Mark to market (MTM), you would have earned Rs 5,000 (210-200=10*500) at the end of 3rd day.
Due to mark to market, instead of waiting for 3 days to close the position, profit and losses are settled daily in your trading account.
Here is how Mark to Market (MTM) is applied;
Day 1
- Buying price = Rs 200
- Closing price= Rs 205
- Profit = Rs 5
- Day 1 MTM gain = profit per unit * lot size = Rs 5 * 500 = Rs 2,500
Day 2
- Closing price of Day 1 = Rs 205
- Closing price of Day 2 = Rs 210
- Profit = Rs 5
- Day 2 MTM gain = profit per unit * lot size = Rs 5 * 500 = Rs 2,500
Day 3
- Closing price of Day 2 = Rs 210
- Selling price on Day 3 = Rs 210
- Profit = Rs 0
- Day 3 gain = 0
- Total gain = Day 1 Gain + Day 2 Gain + Day 3 Gain = Rs 2,500 + Rs 2,500 + Rs 0 = Rs 5,000
- Gain as per Mark to market (MTM) is the same as your profit i.e. Rs 5,000.
At the end of the 3rd day, your account will be settled with the gain.
If your position is in loss and you don’t have sufficient balance in your account, the position might be squared off and a margin penalty will be levied.
