Mark to Market: How Gain and Loss Are Recognised Daily

Mark to market recognises a position's gain or loss every day against that day's stated settlement price, and moves cash to match it, instead of waiting for expiry. The total over the life of the contract is the same either way. Daily marking changes the timing of the cash, and a position can end early because the cash ran out.

A promise that runs for months leaves each side relying on the other for months, and the longer that reliance runs the larger the amount that has quietly built up behind it. Marking daily replaces one large reliance at the end with a run of small ones, each settled on the day it arises. Because nothing has been added or removed, the total cannot change. Because the settling now happens on days rather than on one day, the timing cannot stay the same.

What does marking a position to market actually do?

Two things happen, and they are worth holding apart because readers routinely collapse them into one. First, the gain or loss on the position since the previous day is recognised. Second, cash moves to match it, from the side that lost to the side that gained. Recognition and the cash that follows it, taken together on a stated day, are what the word markThe recognition of gain or loss on an open position for one day, and the cash movement that follows it. means here.

Nothing else moves. The obligation each side took on is exactly what it was yesterday. The price the two sides agreed to trade at is exactly what it was yesterday. And nothing at all has happened to the underlying itself. The underlying sits outside the contract and has no idea a mark was taken. A mark is a piece of bookkeeping between two sides of a promise, made real by cash. A mark is not a revaluation of anything in the world.

The everyday version is two neighbours who share a wall and keep borrowing small amounts from each other. The neighbours could keep one running tab and settle it next Diwali. Or they could square up every evening before bed. The tab reaches the same total either way, down to the last rupee. But only one of the two arrangements can end with somebody owing a year of borrowings in a single lump, and only one of the two asks each neighbour to find a little cash on a Tuesday evening that they had not planned on finding. Daily marking is the evening settle. Everything difficult about it comes from the Tuesday, not from the total.

The single most costly misreading of daily marking is that a mark is a part payment of the agreed price, and it is not. The two sides have agreed to trade at a stated price on a stated date. Not one rupee of that price has been paid while the contract runs. The gain or loss between them since the day before is what moves each day, and the amount posted is a cushion, not an instalment. If a position is entered at an agreed price of Rs 2,130.00/-, then after two days, five days or a hundred days of marks, the amount of that Rs 2,130.00/- that has been paid is still nil.

Which price is a position marked against, and who fixes it?

Not against whatever number a reader happens to have in front of them. A position is marked against a stated daily settlement priceThe one stated price a position is marked against for a given day, arrived at in a stated way by a stated party at a stated moment.: one price, arrived at in a stated way, by a stated party, at a stated moment of the day. Every mark on every position that references that contract is taken against that one figure.

The settlement price is a term of the arrangement and not a detail of it. Two sides who agree on the underlying, the date, the price and the quantity, and who then disagree about which price the day closed at, have not actually agreed on anything that can be settled. The whole mechanism of daily marking depends on there being exactly one number, known to both, that neither of them chooses. The settlement price is therefore defined in advance rather than found on the day, and defined by somebody who is not one of the two sides.

How a daily settlement price is arrived at, by whom, and at what moment of the day, is set by the Securities and Exchange Board of India (SEBI) at sebi.gov.in for exchange traded contracts, and it moves. Five requirements including that one are named below, each against the authority that sets it.

Is the settlement price the same thing as the price of the underlying?

No. Confusing the price of the contract with the price of the underlying is the commonest error in the whole subject. A position in a contract is marked against the price of the CONTRACT. The price of the underlying is a different price with a different number attached to it, and the two do not move by the same amount while the contract still has life left in it.

The figures already given settle it. The invented reference asset used throughout has a spot price of Rs 2,000.00/-, financing costs 6.50 per cent a year, and it pays nothing at all while it is held. Carrying the spot for one year gives Rs 2,000.00/- multiplied by 1.065, or Rs 2,130.00/-. The one year contract price is therefore Rs 2,130.00/-, and Rs 130.00/- of it is the carry. The Rs 130.00/- is arithmetic. Carry is a cost of holding, not anybody's view about where the price goes.

Now suppose the spot reads Rs 1,920.00/- with a year still to run. The spot is now a gap of Rs 80.00/- from the Rs 2,000.00/- it started at. But the carry applies to the new spot as well: Rs 1,920.00/- multiplied by 1.065 is Rs 2,044.80/-, so the contract price has gone from Rs 2,130.00/- to Rs 2,044.80/-, a gap of Rs 85.20/-. With a year still to run, a gap of Rs 80.00/- in the spot is a gap of Rs 85.20/- in the contract, and the position is marked on the second figure rather than the first. At the final date, and only at the final date, there is no carry left to apply, so the two gaps become the same.

Two habits come out of those two prices, and both are worth keeping for the rest of this subject. The first is to write every move as the gap between two stated prices, with the base attached, rather than as a percentage floating free of what it is a percentage of. The second is that whenever one position is set against another and the two are claimed to cancel, the moment being worked at has to be stated. A cancellation that holds on the final date does not hold on any day before it.

What does the five day path look like, day by day?

Take a position long the contract at Rs 2,130.00/-. Five days pass, and on each of them a daily settlement price for the contract is stated. The five settlement prices below are chosen, not measured. A chosen path shows what a mark does on each of five days, and it shows nothing about how often a day of that size arrives. How often is a question about distribution, and one path answers none of it.

The settlement prices are Rs 2,110.00/-, Rs 2,050.00/-, Rs 2,170.00/-, Rs 2,150.00/- and Rs 2,210.00/-. Each day's mark is that day's settlement price less the previous day's, and on the first day the previous figure is the price the position was entered at.

Look at the third column of the table before anything else. The third column is the one most readers skip. Day three's mark of plus Rs 120.00/- is measured from Rs 2,050.00/-, where day two left the position, and not from Rs 2,130.00/-, where the position started. Measured from the entry price the day three figure would be plus Rs 40.00/-, and it would be wrong. The Rs 80.00/- already recognised over the first two days would be counted a second time. The reset to yesterday's figure is what stops the same movement being recognised twice.

Do the daily marks add up to the same total?

The five marks do, and adding them settles the matter by arithmetic rather than by assertion. The five marks are minus Rs 20.00/-, minus Rs 60.00/-, plus Rs 120.00/-, minus Rs 20.00/- and plus Rs 60.00/-. Minus Rs 20.00/- and minus Rs 60.00/- come to minus Rs 80.00/-. Adding plus Rs 120.00/- reaches plus Rs 40.00/-. Taking away Rs 20.00/- reaches plus Rs 20.00/-. Adding plus Rs 60.00/- finishes at plus Rs 80.00/-.

Now take the same position in a single step. The final settlement price is Rs 2,210.00/-. The price the position was entered at is Rs 2,130.00/-. Rs 2,210.00/- less Rs 2,130.00/- is plus Rs 80.00/-. The two roads reach the same figure, and they will always reach the same figure.

The reason is worth seeing written out rather than accepted. Each mark measures from where the previous one finished, so every intermediate settlement price appears exactly twice in the sum: once as an addition, when it is the day's price, and once as a subtraction, when it becomes the day before's price. Add a figure and subtract the same figure and it is gone. The collapsing of a run of differences to its two ends is telescopingThe way a run of consecutive differences collapses, because every figure in the middle appears once with a plus and once with a minus and so cancels itself., and the picture below strikes out the eight figures that cancel, leaving what survives to be counted.

Marking daily is not a different answer to the same question, it is the same answer taken in instalments. The flatness is deliberate. A great deal of anxiety about daily marking comes from a suspicion that the instalments somehow add up to more than the lump. They cannot. Adding a figure and subtracting the same figure leaves nothing behind, however many times it is done.

If the total is unchanged, what does daily marking change?

The days. The days are the whole of the answer, and the answer is not a small one.

Settled once at the end, this position produces a single movement of cash: plus Rs 80.00/- arriving on the final day, and nothing at all on the four days before it. Marked daily, the same position produces five movements: cash out on day one, out again on day two, in on day three, out on day four and in on day five. Same total, five different days, and four of those days did not exist as cash events under the other arrangement.

A position whose total is a gain can still require cash from the holder on several of the days in between, and being required to produce cash is not the same thing as losing money. Read that twice. On day one this holder pays out Rs 20.00/-. On day two they pay out Rs 60.00/-. Both of those are real cash leaving a real account, and both of them are happening to a position that will finish plus Rs 80.00/- ahead. Under the settle-once arrangement neither payment would have happened. The gain is identical; the experience of holding it is not remotely identical.

What happens to the amount posted across the same five days?

An amount sits against the position while it runs. The amount posted is the marginThe amount posted against an open position while it is running, which stands behind the promise rather than paying any part of the agreed price., and the marks are taken out of it and paid back into it as the days pass. Take an exposureThe amount of the underlying that a position actually stands against, as distinct from the amount posted or the amount that changes hands. of Rs 2,000.00/-, one unit of the invented reference asset at its spot price. A margin of 8.0 per cent of that exposure is Rs 160.00/-. The 8.0 per cent is a chosen rate and not a requirement of any kind: a fixed rate lets the arithmetic be worked at all.

Run the five marks through the Rs 160.00/- and print the balance at the close of each day. Rs 160.00/- less Rs 20.00/- is Rs 140.00/-. Rs 140.00/- less Rs 60.00/- is Rs 80.00/-. Rs 80.00/- plus Rs 120.00/- is Rs 200.00/-. Rs 200.00/- less Rs 20.00/- is Rs 180.00/-. Rs 180.00/- plus Rs 60.00/- is Rs 240.00/-.

Stop at day two and read it carefully. Every ratio there needs its base said in the same breath. By the close of day two the settlement price stands at Rs 2,050.00/- against a price entered at Rs 2,130.00/-, a gap of Rs 80.00/- against the position. Set that Rs 80.00/- against the exposure of Rs 2,000.00/- and it is 4.0 per cent of the exposure. Set the same Rs 80.00/- against the Rs 160.00/- posted and it is 50.0 per cent of what was posted. One amount of rupees, two entirely different bases, and a reader who names neither of them will find the second figure surprising for no good reason.

The other half of that same fact is the leverage sitting underneath it. Rs 2,000.00/- of exposure standing on Rs 160.00/- posted is 12.50 times. Which means that each 1.0 percentage point of move against the exposure takes 12.50 per cent of what was posted, every time, by arithmetic. Four of those percentage points is half of it.

The everyday version is a household that keeps a fixed float in a kitchen drawer for the milk and the newspaper. The float is small and the household's actual spending is large, so a single unusual week does not look big against the month's spending and empties the drawer anyway. Nothing about the household changed. The drawer was simply never sized against the week.

Dragged, the control reaches the finding absurdly early. The control only runs to 8.0 per cent of the exposure. At 8.0 per cent the whole of what was posted has gone, and half of it has gone barely past the middle of that short range. The two bars are drawn at the same height, and each one says on its face what that height means: the left bar is Rs 2,000.00/- from top to bottom and the right bar is Rs 160.00/-, so one rupee is not the same height in the two. Reading the two heights as the same rupees is exactly the comparison a reader makes silently and wrongly.

What happens when the balance runs down?

Cash is called for. The demand is the whole of it, stated plainly: a stated amount, to be produced by a stated time. A demand of that kind is a callA demand for further cash against an open position, made when the amount posted has run down below what must be held., and it is what keeps the arrangement working when marks have eaten into the cushion.

Two roads run out of that morning and there are only two. If the cash arrives, the balance is restored and the position carries on, unchanged in every other respect. If the cash does not arrive, the position is closed outThe ending of an open position by the party standing behind the arrangement, rather than by either of the two sides deciding to end it. by the party standing behind the arrangement, and the holder is left with the losses already recognised and no position at all.

An order fixed in advance is what stops each shortfall being negotiated on the morning it arrives, so the order matters more than any step in it. Two sides arguing about how long is long enough, on a day when one of them is short of cash, would reach a different answer every time and a worse one each time the amounts got larger. The protection is that nobody decides anything on the day. The time by which a shortfall is to be met, and what follows if it is not, is set by SEBI at sebi.gov.in, and it moves.

Why can a position end before expiry when the obligation never changed?

A position ending early is the part that surprises people, and it is worth being blunt about why. Nothing about the contract failed. The other side did not refuse to perform. Nothing about the promise was ever in doubt. Cash ran out, in one account, on one particular morning, before a stated hour. The position ended for a reason that lives entirely outside the contract.

A shopkeeper who knows the month will finish profitable and cannot pay Tuesday's supplier is in the same position, and nobody would say the shop was unprofitable. Everyone would say the shop ran out of cash on a Tuesday. A shortage of cash and a loss are different things, and telling them apart is most of what daily marking asks of a holder.

Why are the total and the experience different things?

Because they are answers to different questions, and this is the finding to carry away. Take the same position twice. Settled once at the end, it produces plus Rs 80.00/- and nothing else ever happens. Marked daily, it produces plus Rs 80.00/- and also produces a morning on which 50.0 per cent of what was posted had gone.

The total is unchanged and the path is not, and a holder who could not meet the day two call never reached the plus Rs 80.00/- at all. Both halves of that sentence have to be said together. Either half on its own is misleading. Said alone, the total being unchanged describes an arrangement nobody would fear. Said alone, half of what was posted vanishing on day two describes a loss that never actually happened.

What does marking a position not do?

Three doors close at once here, and it is worth shutting them deliberately.

1. A mark does not establish the contract's value.A mark reads a stated settlement price and takes a difference from the previous stated settlement price. There is no model in it, no rate applied, no judgement exercised. Working out what a contract is worth from first principles is a different exercise with different inputs, and where an option is concerned it needs a measure of how much the price moves about, and a settlement price never carries one.
2. A mark does not predict anything.A mark is a record of a day that has already finished. It is the most backward looking figure on a statement. Reading a run of marks as a direction is exactly the error of reading a carry calculation as a forecast, in a different costume.
3. A mark does not remove the obligation.The promise runs to expiryThe date on which the contract's promise ends and nothing further is owed under it. regardless of how many marks have been taken along the way. A position that has been marked ninety times still obliges exactly what it obliged on day one.

How does somebody actually use this on an ordinary morning?

Picture a treasury desk at an invented manufacturer, or for that matter one person with a laptop, opening a statement before anything else happens. Three lines get read, in this order, and the third one is the one nobody but the holder can fill in.

The first line is what last night's mark took. The mark is read off the statement, not worked out, and it is a fact about a day that has finished. The second line is what is left of the balance. The balance decides whether the position survives the morning, and it is the line most people scroll past on the way to something that feels more interesting. The third line is what cash could actually be produced by a stated hour without selling something else. Nobody but the holder knows it, so it is not on the statement at all.

A lender looking at the same statement reads it the other way round. The lender is not interested in the total the position will reach. The lender wants to know how much cash the borrower could be asked for on any given morning, and that demand competes with everything else the borrower owes. Same statement, different line, and the difference between the two readings is the difference between an arithmetic question and a cash question.

Should a position that marks daily be held?

The path of a marked position can now be followed exactly. Following a path is not the same thing as deciding whether to hold one, and the mechanism does not decide it. The reason is worth setting out rather than leaving as a formality.

Four things would have to be known first, and not one of them is arithmetic. The first is what cash the holder could produce on any given morning without selling something else, and no statement anywhere carries it. The second is whether the position stands on its own or against something a reader already owns. A position taken alone and the same position held as a hedge are different arrangements. The third is the whole range of daily paths and how likely each one is, and that needs a distribution rather than one chosen path. The fourth is whether such a position may be taken at all, and SEBI at sebi.gov.in settles that rather than preference.

The five day path above is one chosen path. How often a day like day two arrives, or whether it arrives at all, is a matter of distribution, covered separately. A drawing of what happens at each price describes an obligation, and describing an obligation is neither a prediction nor a suggestion.

Who sets the requirements a marked position runs under?

The reference asset, the manufacturer and every price, mark, balance, rate and ratio in this guide are invented.
Educational material. Not advice on any investment, tax, budget or market position.