EXPLAINER: Mark-to-market is not a 'hair-cut' on your investment

Mark-to-market (MTM) also known as fair value accounting is a concept used in finance and accounting that refers to the process of valuing an asset or liability based on its current market value. The idea behind MTM is that assets and liabilities are constantly changing in value, and therefore, their current market value should be reflected in a company’s financial statements.

In the context of trading, mark-to-market refers to the daily valuation of open positions based on the current market prices. For example, if a trader buys a stock at Ghc50 and the market price rises to Ghc60, the trader has an unrealized gain of Ghc10. This gain is reflected in the trader’s account, and the position is marked to market at Ghc60.

On the other hand, if the market price falls to Ghc40, the trader has an unrealized loss of Ghc10, and the position is marked to market at Ghc40. In this way, mark-to-market accounting allows traders to keep track of their positions and their profit or loss in real-time.

Mark-to-market is also used in accounting to value financial instruments, such as stocks, bonds, and derivatives, at their current market value. This is particularly important for financial institutions, as it allows them to accurately value their assets and liabilities on a regular basis.

Accounting Standards

IFRS (International Financial Reporting Standards) and IAS (International Accounting Standards) are a set of accounting standards developed by the International Accounting Standards Board (IASB) to provide a common global framework for financial reporting. Both IFRS and IAS require the use of mark-to-market accounting in certain circumstances. The accounting standards currently adopted by Institute of Chartered Accountants, Ghana (ICAG) is the International Financial Reporting Standards (IFRS).

Under IFRS, mark-to-market accounting is required for financial instruments that are traded in active markets. This includes assets such as stocks, bonds, and derivatives that have readily available market prices. These financial instruments must be valued at their fair value, which is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

In addition, IFRS requires the use of mark-to-market accounting for financial instruments that are not traded in active markets, but for which there are observable market prices for similar instruments. This is known as a fair value hierarchy, which classifies financial instruments into three levels based on the availability and reliability of market inputs. The higher the level, the more reliable and observable the market inputs are, and the more likely mark-to-market accounting will be used.

IAS also requires the use of mark-to-market accounting in certain circumstances. Under IAS 39, financial instruments that are held for trading, such as stocks, bonds, and derivatives, are required to be valued at their fair value, with changes in fair value recorded in the income statement.

IAS 39 also requires the use of mark-to-market accounting for financial instruments that are designated as financial assets or financial liabilities at fair value through profit or loss (FVTPL). These financial instruments are held for trading or for which the company has elected to use fair value accounting. Changes in fair value are recorded in the income statement.

Sovereign Bonds and MTM

Sovereign bonds are issued by governments and are considered to be low-risk investments, as they are backed by the full faith and credit of the government that issues them. However, the value of sovereign bonds can still fluctuate based on changes in interest rates, credit ratings, and other market conditions. As a result, mark-to-market accounting is used to value these bonds based on their current market value.

For example, if a government issues a 10-year bond with a face value of Ghc1,000 and an interest rate of 20%, and the market interest rates rise to 30%, the bond’s market value will decrease. In this case, mark-to-market accounting would reflect this decrease in value, even though the bond’s face value remains the same.

Collective investment schemes, such as mutual funds, exchange-traded funds (ETFs), and unit trusts, are also subject to mark-to-market accounting. These investment vehicles pool money from multiple investors and invest in a portfolio of assets, such as stocks, bonds, and other securities. The value of these assets can fluctuate based on market conditions, and mark-to-market accounting is used to value the portfolio based on its current market value.

For example, if a mutual fund has a portfolio of stocks that are valued at Ghc10 million and the stock market experiences a downturn, causing the value of the portfolio to decrease to Ghc9 million, mark-to-market accounting would reflect this decrease in value. This would result in a decrease in the net asset value (NAV) of the mutual fund, which is the value of the fund’s assets minus its liabilities divided by the number of outstanding shares.

High Interest Environment and Bonds

In a high interest rate environment, mark-to-market accounting can have a negative impact on the prices of bonds. When interest rates rise, the market value of existing bonds falls, as investors demand a higher yield to compensate for the increased risk of holding lower-yielding bonds. As a result, the prices of bonds decline, and the mark-to-market value of the bonds is adjusted downwards to reflect this change.

For example, consider a bond with a face value of Ghc1,000, a coupon rate of 3%, and a remaining maturity of 10 years. If interest rates rise from 3% to 4%, the market value of the bond will decline, as investors will require a higher yield to compensate for the increased risk. The market value of the bond may fall to Ghc900, reflecting the new, higher yield required by investors.

The impact of mark-to-market accounting on an investment portfolio depends on the extent to which the portfolio is invested in bonds and other fixed-income securities. In general, a portfolio that is heavily invested in bonds may experience a decline in value as interest rates rise and the market value of bonds declines. This is because the mark-to-market value of the bonds in the portfolio will be adjusted downwards to reflect the decline in value.

Conclusion

Investors who are concerned about the impact of mark-to-market accounting on their investment portfolios in a high interest rate environment may consider diversifying their portfolios across different asset classes, such as equities, real estate, and commodities. This can help reduce the overall risk of the portfolio and provide some protection against declines in the value of fixed-income securities due to mark-to-market accounting. Additionally, investors may consider investing in treasury bills with shorter maturities, as these are less sensitive to changes in interest rates and may provide a more stable source of income.