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
Actions
Prices
• Reliance on market prices distorts market
prices
Three Notions of Value
• Fundamental value v
• Book value
v0
• Market price
p  v  s
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 v0
• Book value determined by past decisions
(exogenous to model)
• Common knowledge at time of decision
• Contractible
Market Price
• Market price
p  v  s
• Lower ability to extract value
(  1)
• Limited absorption capacity
(  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
Sell or hold
Date 0
probability 1– d
cash flow v
Date 1
probability d
cash flow v
Date 2
Date 1 Accounting Values
(as seen from decision date)
Hold
historical
cost
mark to
market
1  d v  dv0
1  d v  dp
Sell

v  s
2
Historical Cost Regime
• Sell when v is high relative to v0
– accounting value is excessively conservative
• Sell when others hold
– actions are strategic substitutes
– self-stabilising
Mark to Market Regime
• Sell when v is low relative to v0
– market price is excessively volatile
• Sell when others sell
– actions are strategic complements
– multiple equilibria when v is common
knowledge
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 Uncertainty
in 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?
z
x
x* v*
F(z)
v
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.