What is Marking to Market?
Marking to market involves valuing an instrument based on its current market price. If you buy an option because you believe it is cheap, the profit will not be immediate. You must wait for the market value to match your estimate. Optional events may not occur until they expire. When hedging options, you can choose between using a delta based on implied volatility or your own assessment of volatility. To avoid changes in your mark-to-market P&L, hedge using implied volatility, even if you believe it is incorrect.
A Short Example
A stock is trading at $47, but you believe it is significantly undervalued. You believe the value should be $60. You purchase the stock. What value do you place on your ‘portfolio’? $47 or $60? If you say $47, you’re marking to market. If you say $60, you’re marking to your model. To avoid potential abuse, mark-to-market value is commonly quoted and generally required by regulations. If you are correct about the stock value, profits will be realised as the price increases. Be patient, my son.
A Deep Dive into Marking to Market
Marking to market is basic for liquid, exchange traded assets. You only need the most current market-traded price. However, this does not prevent you from expressing your expected worth and profit. You likely joined the deal with the expectation of profit.
Hedge funds provide Net Asset Value to investors based on the mark-to-market value of liquid instruments in their portfolio. Estimating future profits is a risky endeavour.
Futures and short options typically require daily margin payments to a clearing house to mitigate credit risk. If prices shift against you, you may need to pay a maintenance margin. This is based on current market values for futures and short options. (Long options positions have no margin because they are paid in advance, resulting in only positive outcomes.)
The process of marking exchange-traded instruments to market is basic. What about exotic or over-the-counter contracts? These are not traded actively and may be unique to you and your counterparty. These instruments must be tagged according to model.
This brings up the question of which model to utilise. The term’model’ typically refers to volatility in various markets, such as stock, forex, or fixed income.
Choosing a model becomes a matter of determining the appropriate volatility.
Possible ways of marking OTC contracts.
- The trader applies his own volatility. This may be his best prognosis for the future. This method is easily abused and can result in an inflated profit margin.
The volatility employed should be comparable to the implied volatility of liquid options with the same underlying. - Use the pricing obtained from brokers. This has the virtue of being actual, tradeable, and unbiased. The primary disadvantage is that you cannot constantly call brokers for pricing information without trading. They get quite irritated. They no longer offer Wimbledon tickets.
- Use a volatility model tuned for vanillas.
This approach provides market-consistent prices that are not subject to arbitrage. The choice of volatility model (deterministic, stochastic, etc.) affects ‘arbitrage freeness’, which is subjective. Constantly crunching prices might be time-consuming.
The Hidden Volatility Risk: Marking to Market vs. Reality
One complication concerns the marking procedure and derivative hedging. Consider the simple example of a vanilla equity option purchased because it is considered inexpensive. There are three types of volatility: implied, projected, and hedging.
When trading an option, the implied volatility is likely used to mark it to market. However, the eventual profit depends on the realised volatility (assumed to be as anticipated) and the option’s hedge. Using implied volatility in the delta formula removes random fluctuations in the mark-to-market value of a hedged option portfolio. However, this results in a profit path that is dependent on realised gamma along the stock’s path.
Marking to market or utilising a model-based marking can clearly show losses. If a potentially beneficial trade fails, you may experience significant losses. If the loss exceeds a certain threshold, you may need to close the position. Of course, you might have been correct in the end, only a little off in the time. If you have already closed your position, the loss may not be reversible. Humans often cling onto losing positions for too long, hoping to recover, while closing out winning situations too soon. Marking to market will therefore put some rationality back into your trading.
Related Readings
- Put-Call Parity: All You Need To Know
- Modelling Approaches in Quantitative Finance: All You Need To Know
- Central Limit Theorem In Finance: Power Your Portfolio Now