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Marking to Market

The Litany and the Gluttony

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Marking to market is a financial accounting concept that involves taking an open position and valuing it at the current market price.  Unless the price of the commodity has not changed at all since the position was initiated, this results in a mark-to-market (MTM) or “unrealized” gain or loss on the position.  At some point the position is closed out, at which time the actual or “realized” gain or loss can be calculated.  Marking to market is an enormously useful concept and is widely used across many business applications.  It applies equally to commodities, currencies, stocks, bonds, interest rates and other financial instruments.

On the positive side, marking to market is a sound and healthy practice that allows companies to stay on top of their performance in their business operations, investments, hedging strategies and trading activities.  It also helps shareholders and other stakeholders monitor the company’s performance in a very time sensitive manner.  In the futures market, all positions are marked to market daily (sometimes even intraday), which allows the exchanges and the brokerage houses to keep current with the performance of their customers’ positions through margining and dramatically reduces the chance of a customer default. 

Marking investment portfolios and mutual funds to market is also an indispensable process, which gives investors a timely and accurate picture of the performance of their investments and forms the basis for the calculation of fees charged by the investment advisors, mutual funds, etc.   The reality is that a large portion of the financial industry simple couldn’t function without the ability to mark their positions to market on a daily basis.

But let me give you a few examples of the more troublesome side of the MTM concept.  First there is the spectacular abuse of MTM accounting by Enron.  This is wonderfully captured in one of my favorite books about risk entitled “The Smartest Guys in the Room” by Bethany McLean and Peter Elkind.   Enron took the MTM concept to such an extreme that they were booking projected profits on power plants and other projects many years into the future before the plants were even built.  And of course the projected profits were based on marking to market their own forecasts of future production using their own energy price forecasts.  According to McLean and Elkind, this abuse of the MTM concept was applied widely across Enron’s trading activities.  On the day that Enron received approval from the SEC to use MTM accounting, Jeff Skilling and his trading group reportedly had champagne brought in to toast the new accounting change. 

The abuse of MTM by Enron was wrong on so many levels it is hard to know where to begin.  First, the ability to recognize profits on deals as they were booked led to the payment of huge bonuses on contracts that would not be fully delivered upon for many years to come.  Once the deals were done, the traders were on to the next deal, leaving the fulfilment of the contracts for someone else to worry about.  The temptation to inflate the projected profit was also impossible to resist, particularly when everyone was receiving huge bonuses off the deals, including senior management.  Then there is the inevitable mismatch between profits and cash.  It is one thing to book projected profits upfront on a 20-year deal, but the actual cash rolls in gradually as the contract is fulfilled.  This led to other creative accounting techniques to paint over the gap between reported profit and cash flow.  And finally, the only way to keep up the earnings growth that Enron followers were told to expect, was to do more deals with similar MTM accounting treatment.  The rest is history.

Secondly, there is the issue of marking to market hedge positions, and specifically when and how to recognize MTM or “unrealized” hedge gains and losses in net profit or loss for financial reporting purposes.  For a bona fide hedge, it clearly makes no sense to recognize unrealized hedge gains or losses as profit or loss unless the corresponding change in value on the underlying asset that is being hedged are being recognized as profit or loss at the same time.  While the ever-evolving financial reporting standards (such as IAS 39 under IFRS) do provide for different forms of hedge accounting, the sheer complexity of it has discouraged many companies from using hedge accounting.  The problem with this is that unrealized gains on losses on hedge positions can cause large swings in reported income from quarter to quarter, when in reality these unrealized hedge gains and losses have a corresponding gain or loss on the underlying asset that is not being recognized.  To compensate for this, some companies publish an adjusted statement of earnings where they back out the unrealized hedge gains or losses to give a more accurate picture of financial performance to their shareholders. 

Fair value hedge treatment under IAS 39 basically allows both the hedging instrument and the hedged item to be marked to market in cases involving a clearly defined asset, liability or firm commitment.  This makes a huge amount of sense, as it also picks up any gains or losses in the basis (i.e., where the hedging instrument and the hedged item do not move in perfect tandem).   The problem is that it creates a lot of work for those having to mark to market the hedging instrument and the hedged item.  Qualifying for hedge accounting treatment also requires meeting hedge effectiveness tests which creates even more work for the company. 

The third problematic area for marking to market involves cases where there is no visible, transparent and reliable market price to use for valuation.  There are hoards of cases where the commodity or financial asset involved does not have any public form of price discovery such as a futures contract, and thus estimates have to be made regarding the fair market value.  There are also many cases where there is an underlying futures price to use for valuation, but the deal extends beyond the timeframe of the futures market.  This opens the door to debates over how best to estimate a market value and the temptation to use “favorable” MTM values to dress up positions.  This is where having a clear separation between the trading and risk oversight functions in commodity-based organizations is very important and the risk oversight group must play a role in validating the methodologies used to establish MTM valuations.  The auditors will also have something to say about this.

There is an interesting psychological aspect to taking any asset and constantly marking its value to market.  While the share value of a publicly-traded company is constantly bouncing around, it is hard to imagine that its true long term value is really changing that much from minute-to-minute or day-to-day.  However, many investors and traders have a hard time resisting the temptation of watching the “real time” value of their investments and often reacting to short term fluctuations in market value. 

You have likely heard some of the investor legends like Warren Buffet say “we don’t buy stock, we buy companies”.  What they are getting at is that they look at the long term prospects of the company and try not to get distracted by the day-to-day machinations of the market.  Having the ability to monitor the MTM value of your investments on a minute-to-minute basis is great in one sense, but it also drives many investors to make bad decisions based on short term valuations of their investments.  Ring any bells?

In some companies, the MTM value of hedge positions seems to attract a lot of unwarranted attention, particularly when the hedge is in a negative position and the hedged item is in a positive position.  In companies for which hedging is a discretionary activity (i.e., they don’t do it on a regular or routine basis), the MTM value of the hedge can be a flashing red light of how well they did in timing the execution of their hedge.  Had they made exactly the same pricing decision by selling forward in the cash market, odds are that it would receive very little attention.  Companies with a mature risk attitude and approach are much better at clearly defining their objectives and expectations regarding hedging and thus are much less likely to fall into the trap of fretting over unrealized hedge gains or losses.

Let me close off by reiterating that the concept of marking to market is a highly logical and healthy practice and an indispensable part of many modern day markets.  Hopefully this short article has highlighted some of the potential pitfalls in this otherwise very useful concept.

Ron R. Gibson


Gibson Capital Inc.
Calgary, Alberta, Canada

Email: info@gibsoncapital.ca

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