Mark-to-Model refers to the practice of pricing a position or portfolio at prices determined by
financial model
Financial modeling is the task of building an abstraction, abstract representation (a mathematical model, model) of a real world finance, financial situation. This is a mathematical model designed to represent (a simplified version of) the perfor ...
s, in contrast to
allowing the market to determine the price. Often the use of models is necessary where a market for the financial product is not available, such as with
complex financial instruments. One shortcoming of Mark-to-Model is that it gives an artificial illusion of liquidity, and the actual price of the product depends on the accuracy of the financial models
used to estimate the price.
On the other hand it is argued that Asset managers and Custodians have a real problem valuing illiquid assets in their portfolios even though many of these assets are perfectly sound and the asset manager has no intention of selling them. Assets should be valued at mark to market prices as required by the Basel rules. However mark to market prices should not be used in isolation, but rather compared to model prices to test their validity. Models should be improved to take into account the greater amount of market data available. New methods and new data are available to help improve models and these should be used. In the end all prices start off from a model.
Hedge Funds
Hedge fund
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as sho ...
s may use mark-to-model for the illiquid portion of their book.
Another shortcoming of mark-to-model is that even if the
pricing models are accurate during typical market conditions there can be periods of market stress and
illiquidity
In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the ...
where the price of less liquid securities declines significantly, for instance through the widening of their
bid-ask spread.
The failure of
Long-Term Capital Management
Long-Term Capital Management L.P. (LTCM) was a highly-leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York.
LTCM was founded in 1 ...
, in 1998, is a well-known example where the markets were shaken by the
Russian financial crisis, causing the price of
corporate bonds
A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business. The term is usually applied to longer-term debt instruments, with maturity of ...
and
treasury bonds
United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Since 2012, U.S. gov ...
to get out of line for a period longer than expected by the LTCM's models. This situation caused the hedge fund to melt down, and required a Fed bailout to prevent the toxicity from spilling into other financial markets.
Enron Collapse
The collapse of
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. It was founded by Kenneth Lay in 1985 as a merger between Lay's Houston Natural Gas and InterNorth, both relatively small regional companies. ...
is a well-known example of
the risks and abuses of Mark-to-Model pricing of
Futures contracts
In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...
. Many of Enron's contracts were difficult
to value since these products were not publicly traded, thus computer models were used to generate prices. When Enron's profits began to fall with increased competition, accounts manipulated the
mark-to-market
Mark-to-market (MTM or M2M) or fair value accounting is accounting for the "fair value" of an asset or liability based on the current market price, or the price for similar assets and liabilities, or based on another objectively assessed "fair" ...
models to put a positive spin on Enron's earnings.
Criticism
In 2003,
Warren Buffett
Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net w ...
criticised mark-to-model pricing techniques in the
derivatives
The derivative of a function is the rate of change of the function's output relative to its input value.
Derivative may also refer to:
In mathematics and economics
* Brzozowski derivative in the theory of formal languages
* Formal derivative, an ...
market for bringing on "large scale mischief" and degenerating
into "mark-to-myth".
[Berkshire Hathaway annual report 2002]
Warren Buffett on Derivatives
(PDF
Portable Document Format (PDF), standardized as ISO 32000, is a file format developed by Adobe in 1992 to present documents, including text formatting and images, in a manner independent of application software, hardware, and operating systems. ...
)
See also
*
Arbitrage-Free Model
*
Mark to market
Mark-to-market (MTM or M2M) or fair value accounting is accounting for the "fair value" of an asset or liability based on the current market price, or the price for similar assets and liabilities, or based on another objectively assessed "fair" ...
References
SEC gives banks more leeway on mark-to-market*
Level 1, Level 2, Level 3 Assets
Level or levels may refer to:
Engineering
*Level (instrument), a device used to measure true horizontal or relative heights
*Spirit level, an instrument designed to indicate whether a surface is horizontal or vertical
*Canal pound or level
*Regr ...
Derivatives (finance)
Valuation (finance)
Financial models
Enron