by Mark–to–Market (MTM) is a fundamental concept in futures trading, ensuring that the profits and losses on open futures positions are settled daily. It is a mechanism that calculates and records the daily gains or losses of a futures contract based on the closing market price, helping to manage credit risk and maintain market integrity. MTM makes the futures market transparent, reducing the risk of default by either party in the contract.
Understanding Futures Contracts:
A futures contract is a standardized agreement to buy or sell an underlying asset—such as commodities, stocks, or currencies—at a predetermined price on a specified future date. Unlike traditional contracts settled only on maturity, futures are marked to market daily. This means the value of the contract is recalculated every trading day according to the latest market price.
What is Mark-to-Market (MTM)?
Mark-to-Market is the process of adjusting the value of an open futures contract to reflect current market prices. At the end of each trading day, the exchange compares the previous day’s settlement price with the current day’s closing price. The difference, positive or negative, represents the trader’s daily profit or loss.
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If the price moves favorably for the trader, the profit is credited to their account.
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If the price moves unfavorably, the loss is debited from their account.
This daily settlement ensures that gains and losses are realized immediately rather than only at contract expiry, minimizing credit risk.
Why is MTM Important in Futures Trading?
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Credit Risk Management:
MTM limits counterparty risk by ensuring that losses are settled daily, preventing accumulation of large unpaid losses.
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Transparency and Fairness:
It provides an accurate and current valuation of open positions, reflecting real market conditions.
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Liquidity Maintenance:
By settling profits and losses daily, traders are motivated to maintain adequate margin, promoting liquidity and financial discipline.
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Preventing Default:
MTM ensures traders meet margin requirements daily, reducing the chance of default at contract maturity.
How MTM Works: Step-by-Step Example?
Suppose an investor buys one futures contract of a commodity at Rs. 1,000. The contract size is 100 units.
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Day 1 Closing Price: Rs. 1,010
Price increase = Rs. 10 per unit
Daily gain = 10 x 100 = Rs. 1,000 credited to the investor’s account.
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Day 2 Closing Price: Rs. 1,005
Price decrease = Rs. 5 per unit
Daily loss = 5 x 100 = Rs. 500 debited from the investor’s account.
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Day 3 Closing Price: Rs. 1,020
Price increase = Rs. 15 per unit from previous close
Daily gain = 15 x 100 = Rs. 1,500 credited.
Every day, the investor’s margin account is adjusted by these profits and losses. If losses reduce the margin below a specified maintenance margin, a margin call is triggered, requiring the investor to deposit additional funds.
Margin and MTM:
Margins are closely linked to MTM. Initially, traders must deposit an initial margin—a security deposit to cover potential losses. Throughout the contract’s life, the margin account is adjusted daily based on MTM. If losses cause the margin to drop below the maintenance margin, the trader receives a margin call to top up funds.
This process ensures that traders always have sufficient funds to cover potential losses, reinforcing market stability.
Role of Clearinghouse in MTM:
The clearinghouse acts as the counterparty to both buyer and seller in futures contracts. It guarantees performance and handles the daily MTM process. The clearinghouse:
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Calculates daily gains and losses for all open positions.
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Adjusts traders’ margin accounts accordingly.
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Ensures that funds are transferred from losing traders to winning traders.
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Issues margin calls if necessary.
This central role minimizes counterparty risk and boosts confidence in the futures market.
Benefits of MTM in Futures:
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Risk Reduction: Daily settlements reduce the build-up of large unpaid losses.
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Market Discipline: Traders maintain adequate margins, promoting prudent risk management.
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Price Transparency: MTM reflects true market values daily, aiding informed decisions.
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Default Prevention: Ensures financial obligations are met promptly, protecting all participants.
Challenges of MTM:
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Volatility Impact: In highly volatile markets, daily margin calls may be frequent, stressing traders’ liquidity.
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Operational Complexity: Daily settlements require robust systems and monitoring.
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Psychological Pressure: Daily losses can affect trader behavior and decision-making.
