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 abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio o ...
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 Pooling (resource management), pooled investment fund that holds Market liquidity, liquid assets and that makes use of complex trader (finance), trading and risk management techniques to aim to improve investment performance and ...
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 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 ...
, in 1998, is a well-known example where the markets were shaken by the
Russian financial crisis, causing the price of
corporate bonds and
treasury bonds 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 development, energy, Commodity, commodities, and services company based in Houston, Texas. It was led by Kenneth Lay and developed in 1985 via a merger between Houston Natural Gas and InterNorth, both re ...
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 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 item tr ...
. 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 investor and philanthropist who currently serves as the chairman and CEO of the conglomerate holding company Berkshire Hathaway. As a result of his investment success, Buffett is ...
criticised mark-to-model pricing techniques in the
derivatives 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 Inc., Adobe in 1992 to present documents, including text formatting and images, in a manner independent of application software, computer hardware, ...
)
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" ...
*
Model risk
In finance, model risk is the risk of loss resulting from using insufficiently accurate models to make decisions, originally and frequently in the context of valuing financial securities.
Here, Rebonato (2002) defines model risk as "the risk of ...
References
SEC gives banks more leeway on mark-to-market*
Level 1, Level 2, Level 3 Assets
Derivatives (finance)
Valuation (finance)
Financial models
Enron