Marking to Market:Panacea or Pandora’s Box?

Guillaume Plantin

Haresh Sapra

Hyun Song Shin

Case for Marking to Market

• Market price reflects current terms of trade between willing parties

• Market price gives better indication of current risk profile– Market discipline– Informs investors, better allocation of resources

What about volatility?

• If the fundamentals are volatile, then so be it.

• Market price is volatile…

• …but it simply reflects the volatility of the fundamentals

Theory of the Second Best

• When there is more than one imperfection in an economy, removing one of them need not improve welfare.

• In the presence of other imperfections (illiquidity, agency problems, etc.) marking to market need not be welfare improving.

“Artificial” Volatility

• Dual role of market price– Reflection of fundamentals – Influences actions

• Reliance on market prices distorts market prices

Actions Prices

Three Notions of Value

• Fundamental value v

• Book value

• Market price

0v

svp

Fundamental Value v

• Not contractible

• But firm has good information on v– v is common knowledge (base case)– v is observed with negligible noise (main

model)

Book Value

• Book value determined by past decisions (exogenous to model)

• Common knowledge at time of decision

• Contractible

0v

Market Price

• Market price

• Lower ability to extract value

• Limited absorption capacity

svp

)1(

)0(

Interpretation of Strategic Effects

• Marketable assets and possibility of “liquidity holes”

• Hedging credit risk against spike in spreads – Loan sales– Credit derivatives– “reach for yield”

Horizon Mismatch

• Manager chooses at date 0– Sell asset (buy default protection)– Hold asset

• Aims to maximize date 1 accounting value– depends on accounting regime in place

• But asset may be long-lived…

Duration of Asset

Date 0 Date 1 Date 2

Sell or hold probability dcash flow v

probability 1– dcash flow v

Date 1 Accounting Values(as seen from decision date)

Hold Sell

01 dvvd

dpvd 1

sv2

historicalcost

mark tomarket

Historical Cost Regime

• Sell when v is high relative to – accounting value is excessively conservative

• Sell when others hold– actions are strategic substitutes– self-stabilising

0v

Mark to Market Regime

• Sell when v is low relative to – market price is excessively volatile

• Sell when others sell– actions are strategic complements– multiple equilibria when v is common

knowledge

0v

Global Game

• Firm observes v with small noise

• Take limit as noise tends to zero

• Unique equilibrium– Fundamental uncertainty dissipates but

strategic uncertainty remains

Shape of Strategic Uncertaintyin Global Game

• Conditional on being at switching point, what is the density of s?

• Answer: In the limit as noise tends to zero, s is uniformly distributed on [0, 1]– Morris and Shin (2003)

• “I am the marginal player. What is the probability that proportion z or less have signal lower than me?”– (i.e.) What is F(z), the value of the cumulative

distribution function of s evaluated at z?

v

x

z

v*x*

F(z)

x* v*

• Answer:F(z) = z

• Cumulative distribution function is the identity function

• So, density over s is uniform

Historical Cost Regime

• Sell when v is high

• Hold when v is low

• Interior solution for intermediate v

Mark to Market Regime

• Hold when v is high

• Sell when v is low

• Unique equilibrium in switching strategies

Equilibrium Date 1 Price

Equilibrium Loss

Effect of Duration

Effect of Illiquidity

Marking to Market is Superior when Asset is

• Liquid– minimise feedback through strategic

complementarity

• Junior– limited downside potential, large upside (e.g.

stocks)

• Short-lived– minimise effect of horizon mismatch

Damage from Marking to Market is Large when Asset is

• Illiquid– Stronger strategic effects

• Senior– limited upwide, large downside (e.g. loans,

insurance liabilities)

• Long-lived– Greater horizon mismatch

Winners and Losers

• Political Economy of IAS 39

• Banks and insurance companies have been the most vocal critics.

• Institutional investors, securities regulators and auditors have been the most vocal supporters.