Risk Management in Trading: Techniques to Drive Profitability of Hedge Funds and Trading Desks

CHAPTER 5 Mark to Market

Once a trade has been made, traders have to calculate profits and losses on a regular basis. Commonly, this is done daily by comparing recent transaction prices to the previous day’s price. For some financial instruments, finding the current price is as simple as checking the last traded price from an exchange feed. For other investments, finding the current value requires complex modeling.

For investments that can’t be easily liquidated, trying to calculate a market price is both challenging and risky. In these cases, market prices may not be representative of the true value of the asset. Traders holding an illiquid position might not have the ability to trade at prices being reported by other traders. These positions are particularly vulnerable to market panic or manipulative transactions made by other traders. A large number of financial disasters have resulted from nuances of mark-to-market accounting and risk management limits.

A daily process of valuing trading positions is a way to control risk. By understanding what is occurring each day, business leaders can track the performance of each trading strategy as well as the firm’s overall results. That allows business leaders to make decisions on whether to increase or decrease each investment or pay to transfer some risk to other parties.

PROFITS AND LOSSES

Mark-to-market accounting, sometimes abbreviated MTM, is a type of fair-value accounting used to value many tradable assets. It uses current ...