mark-to-market explained

When one buys a cash instrument, for example 100 shares of ABC Inc., the payoff is linear (disregarding the impact of dividends). If we buy the shares at $50 and the price appreciates to $75, we have made $2500 on a mark-to-market basis. If we buy the shares at $50 and the price depreciates to $25, we have lost $2500 on a mark-to-market basis.

Instead of buying the shares in the cash market, we could have bought a 1 month call option on ABC stock with a strike price of $50, giving us the right but not the obligation to purchase ABC stock at $50 in 1 month's time. Instead of immediately paying $5000 and receiving the stock, we might pay $700 today for this right. If ABC goes to $75 in 1 month's time, we can exercise the option, buy the stock at the strike price and sell the stock in the open market, locking in a net profit of $1800.

If the ABC stock price goes to $25, we have only lost the premium of $700. If ABC trades as high as $100 after we have bought the option but before it expires, we can sell the option in the market for a price of $5300. The option in this case gives us a great deal of positional flexibility with a different risk/reward profile.

Mark-to-market is a way of accounting for financial products in which an inventory of financial products is revalued a pre-set interval (usually at the end-of-business on a daily basis) at current market rates. The combination of realized and unrealized profit and loss is booked to the profit-and-loss account. Mark-to-market accounting is a good practice for the management of any financial portfolio.

It is mandatory for financial institutions to report their financial accounts in this fashion. In the near future, initiatives like the Financial Accounting Standards Board Statement No. 133 will require mark-to-market accounting from non-institutional end-users, as well.