Welcome back to the derivative segment. We have been covering a whole series of financial derivatives including Forwards, Futures, Options in our previous articles. This one is all about daily settlement of future contracts. A derivative is basically an instrument that derives its value from an underlying security, and a future contract is basically an agreement between two parties to buy or sell an underlying asset with obligation, at a fixed future date. Now, let’s get deeper into it, by discussing what mark to market settlement is.
What is Mark-to-Market Settlement?
Mark-to-market (MTM) settlement is the practice of showing assets at their current market value, instead of showing them cost-less-depreciation i.e. book value. Basically saying it is what it is, but with your accounts.
In very, very simple millennial terms, mark to market settlement is being real. Being real about the figures in your books, in the sense that this practice doesn’t consider the business in isolation by considering price paid for the asset, but shows the value of the business, its assets at the price the market evaluates it to be. Basically, if the said asset was sold at the particular moment, what would be the amount of money that it would generate for the business? Let’s understand with an example, what problem mark-to-market solves exactly?
Suppose a business, say Ford which has been around longer than three generations of most of our families (est. 1903), bought a building in 1920 for $1000 at centre of island of Manhattan, and then Mr. Ford Jr listened to vinyl and danced cause its 1950. Today, that building would be worth approximately 74 gazillion dollars (exaggeration, obviously, but you get the point. For instance, Empire State Building was constructed for about $41 million, currently it is worth approximately $1.89 Billion with a ‘B’ or 47 times its initial value.)
Now, after years of depreciation on the building, its book value after depreciation might even be $1 (it does happen, LIC buildings were once upon a time valued at Rs. 1, entire 15 storey building), which might show the Ford’s net worth way less that what it actually is, which is good for the company because lesser taxes, bad for the government and eventually people (taxes used for public welfare, at least that was the idea.)
The applications are endless, this could show a bank’s actual assets by valuing NPA’s at their actual null value, stocks in a portfolio at their actual value, etc. In fact, not using mark-to-market was one of the causal factors of 2008 subprime crisis, because banks showed illiquid assets that didn’t exist, in their books.
Now that you have a grasp of its importance, let’s understand how M2M affect futures valuation.
How does Market-to-Market affect Futures Valuation?
Let’s first understand how margins work in a futures contract, because it works a little differently than stock margins. You see, margin in a stock trading is basically like a loan, a borrowing against assets. But in Futures, margin is like a cap for losses, sort of like this the maximum amount of permitted loss that you’re allowed to sustain, sort of like a guarantee.
There are two sides of any future’s trade, the buyer of the contract who is bullish about the prices, hence a long position, and the seller of the contract, who is bearish on the prices hence a short position. For any futures trade, there are two requirements, initial margin and minimum margin.
Mark to Market: Example with Futures Contract
Suppose there is a futures contract for potatoes, lot of 1000 each (because potatoes are Rs. 10 each, right? And they’re valued at per piece not weight, right? Look, I am aware, just stick with it, okay?) worth Rs. 10,000 each, and you hold 10 such contracts making your total investment amount to be Rs. 1, 00,000. But the way this contract works is that you won’t need the entire INR 1 Lakh for investment, but less than even a quarter of that. Most brokers require this margin ranging about 3-12% of the contract value.
Let’s assume that initial margin, the margin with which you can enter the contract with, is Rs. 7000. The minimum margin requirement, your broker says, is Rs. 6000. You see, the minimum margin is not a separate margin that your stock broker asks you to deposit, but it is sort of a threshold, meaning to say your account’s margin cannot fall beyond this limit.
Now you deposited the margin, the seller deposited his margin which is also same, and you entered into a contract expiring after 3 months. Then after you entered into the contract, the price of one contract rose from Rs. 10000 to Rs. 11000 each. In this case, the seller, who is in the short position sustains a notional margin loss of Rs. 10000 ( Rs. 1000 * 10 Contracts ), because his entire purpose of being in a short position was the assumption that prices would fall, but now the price has risen and while the market is valuing one contract for Rs. 11000, he still has to sell the contract to you at Rs. 10000.
Here enters mark-to-market settlement.
The entire purpose of this is so that the margin in your account reflects market’s valuation, sort of like saying if the contract expired today how much profit/loss one stands to make. For the seller, currently his margin is negative (Rs. 7000 initial margin – Rs. 10000 Notional Loss = Rs -3000) Here, the seller would require to deposit Rs. 9000 (Rs. 3000 of negative value + Rs 6000 of minimum margin requirement) if he intends to keep the contract, else the broker would settle the contract.
In your account, your margin would be credited with Rs. 10000, the notional profit. This process is done every day till the contract expires, earning the Mark-to-Market (M2M) process the name daily settlement. At the end of the contract, the contract would settle either on cash basis, or delivery.
If the price would have fallen by Rs. 1000 instead of rising, you would be in deficit and would have to deposit Rs. 9000, and the seller would earn Rs. 10000 credit margin.
You may also go through Covered Interest Arbitrage: Meaning, Procedure & Example
Mark-to-Market (MTM) Settlement: Advantages or Benefits
The first, probably greatest advantage that this method provides is that it eliminates the accumulation of losses, reducing the risk of default of contract. Suppose after the margin falls after a certain limit, and any of the party is unable to pay additional margin requirement, the broker would just settle the contract, capping the losses.
As a result, the second advantage this method provides is to clearing houses, in terms of guaranteeing the performance of every contract. This process also happens to be one of the key differences between future contracts and forward contracts, which arises from their key difference of having a third party clearing house to enforce the contract.
Mark-to-Market Settlement: The Bottom Line
Now that you know how margins work, you’re all ready to trade, nothing else to learn.
Wait!! Just Kidding! Trading isn’t that easy.
Disclaimer: There is a high degree of risk involved in stock trading and investing in any risky asset classes. The details given on this website are for informational purpose only and cannot be constituted as professional advice in any regard. Please follow due diligence while investing your money.
Apart from mark-to-market settlement, there is still so much information to grab about types of future contracts, moving averages of directional movements, risks associated with trading, and the list goes on. Keep reading and keep adding to your financial knowledge. That’s what we are here for! To make you well-versed with any complex finance topics. Are you interested in knowing a specific concept? Feel free to discuss in the comments.