refers to the practice of pricing a position or portfolio at prices determined by financial models, in contrast to allowing the market to determine the price. Often the use of models is necessary where a market for the financial product is not available, such as with
complex financial instruments. One shortcoming of Mark-to-Model is that it gives an artificial illusion of liquidity, and the actual price of the product depends on the accuracy of the financial models
used to estimate the price.
On the other hand it is argued that Asset managers and Custodians have a real problem valuing illiquid assets in their portfolios even though many of these assets are perfectly sound and the asset manager has no intention of selling them. Assets should be valued at mark to market prices as required by the Basel rules. However mark to market prices should not be used in isolation, but rather compared to model prices to test their validity. Models should be improved to take into account the greater amount of market data available. New methods and new data are available to help improve models and these should be used. In the end all prices start off from a model.
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s may use mark-to-model for the illiquid portion of their book.
Another shortcoming of mark-to-model is that even if the
pricing models are accurate during typical market conditions there can be periods of market stress and illiquidity where the price of less liquid securities declines significantly, for instance through the widening of their bid-ask spread.
The failure of Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
, in 1998, is a well known example where the markets were shaken by the Russian financial crisis
The Russian financial crisis hit Russia on 17 August 1998. It resulted in the Russian government devaluing the ruble and defaulting on its debt.-Background and course of events:...
, causing the price of corporate bonds and treasury bonds to get out of line for a period longer than expected by the LTCM's models. This situation caused the hedge fund to melt down, and required a Fed bailout to prevent the toxicity from spilling into other financial markets.
The collapse of Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
is a well known example of
the risks and abuses of Mark-to-Model pricing of Futures contracts. Many of Enron's contracts were difficult
to value since these products were not publicly traded, thus computer models were used to generate prices. When Enron's profits began to fall with increased competition, accounts manipulated the mark-to-market models to put a positive spin on Enron's earnings.
In 2003, Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
criticised mark-to-model pricing techniques in the derivatives
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
market for bringing on "large scale mischief" and degenerating