Serving the Quantitative Finance Community

 
User avatar
Paul
Topic Author
Posts: 6604
Joined: July 20th, 2001, 3:28 pm

What is mark to market and how does it affect risk management in derivatives trading?

June 16th, 2003, 1:50 am

from phoena
 
User avatar
granchio
Posts: 0
Joined: July 14th, 2003, 7:10 pm

What is mark to market and how does it affect risk management in derivatives trading?

July 14th, 2003, 9:04 pm

Well, here's my 0.02$, to get you guys started.I assume everybody is familiar with mark-to-markets of liquid exchange traded instruments (and associated margin calls, in some cases).Of course even these instruments are not always marked to markets.The question is the mark-to-market process of OTC instruments (and illiquid listed ones). Different houses have different ways of doing it. Various methods for vanilla options:-trader's whim: (i.e. the trader marks the options to whatever vol he fancies). highly contentious method... obviously. It has one advantage though: it can reduce the pathdependency of PL (e.g. always marking at same vol, say the vol the option was traded at)-direct quotes from IDB's (inter-dealer brokers): plus: they are often reliable and tradable prices. minus: they can be difficult or impossible to get on some underlyings, they can be biased, and finally can't be the only tool because brokers needs to make a living hence don't like quoting without ever trading (hence don't like quoting to the controllers, e.g. accountants, product control groups). -inter~extra polation of forwards and volsurfaces from Totem. Totem is a company which provides quotes on request (by asking contributor banks)plus: easier and more systematic than IDB.minus: much less reliable. quotes are non-tradable. enough said-mix of the above 3: the trader mantains continuosly a volsurface to the best of his market knowledge using IDB daily quotes, trades and listed option markets (and quote requests), combined with a sensible parametrization of the surface (ideally arbitrage free) and a gentle prod from some kind of independent controller.plus: should be the best approximation to "the market"minus: still open to misuse. require full time traders, with not too many underlyings to follow (how many depends on the business model), and a savvy controller (ideally and ex-trader). the qeustion of what is a sensible parametrization is also debatable and debated.For exotics: just extend/escalate the above. With the massive additional problem of modeling:there is no accepted standard for exotic pricing, and this has huge implication in marking (and pricing, and hedging) some of them, especially barriers (some houses do not take any skew into account), products that depend on forward skew (do you believe in local vol? stoch vol? or maybe constant vol! some houses traded them at flat skew, in the past few years), etc.Mark to market has serious economic impacts, the first ones I can think of are:-obviously, margin calls, either literally (from an exchange) or figurative (from a risk manager, head trader, or similar forcing the closure/reduction of a position). on long dated trades this is unavoidable.-most houses compute their hedge ratios (delta) at the same vol of the mark (there are pros and cons). this means the marking policy will have a serious impact on the hedging strategy, and thus on the pathdependence of the PL. one could think that in some cases, esp. for short dated trades this effect can become dominant, especially if the mark-to-market policy is not well thought out and creates large discontinuoties.In theory, if you had unlimited deep pockets and could take the pain for an unlimited time, you should put on the first prop trade that comes to mind, in as large a size as possible, and earlier or later you'll close it at a profit. Mark to market prevents it: hence we could say that it is a way of defining the scale (and timescale) of the acceptable losses, in other words, it defines the risk appetite. Must be time to go to sleep...
 
User avatar
mrbadguy
Posts: 2
Joined: September 22nd, 2002, 9:08 pm

What is mark to market and how does it affect risk management in derivatives trading?

July 17th, 2003, 1:05 pm

Well, first of all thanks to Granchio for his detailed explanation. To evaluate (an asset, liability, financial instrument, etc) to the current market price, as distinct from historical cost. Marking to market is an important risk-management procedure in financial markets such as derivatives traded, where small price movements can result in large exposures to loss. Marking a portfolio of derivatives and other financial instruments to market means showing the value of the portfolio and the market risk included, and enables decisions about what hedging position should be used. It makes possible for traders to react rapidly to modify their positions. Some international accords recommend that derivatives dealers may mark their portfolios to market daily. Some accounting techniques also require marking to market to represent balance-sheet assets at their current value.To mark to market is to revalue the margin amount to be explicated. The clearinghouse does it on a daily basis. If there is a margin shortfall, the clearinghouse will call for additional collateral from the brokerage firms, which in turn will collect additional collateral from their customers.With respect to risk management purposes Basel Accord mark to market is simply a way to Incorporate Market Risks as allowing financial institutions to apply this method to a significant part of assets of a bank. And the Basel Committee members consider mark to market to be a critical technique within risk management infrastructures, and contributing to efficiency and stability of markets. During using of mark to market accounting method you could recognize all kinds of changes in the risk profile of any position or business or typical actions to reallocate capital resources. First aim is obviously reducing systematic risk introducing mark to market accounting to a wider series of credit sensitive instruments would restrict market discipline, would imply identification of problematic market and credit exposures immediately in advance. Mark to market with respect to risk management couldn’t obviously be limited to derivatives but to repos, traded loans, OTC instruments. If you instead concentrate yourself of fixed income instruments bonds and floating rate notes reflect credit spreads as well yield curve movements and evaluation of market operators on default probabilities.On the other side, marking to market counterparty credit exposure with reference to OTC derivatives (for example plain vanilla swaps) and all other not liquid instruments. Rgds,