marking to market: panacea or pandora’s box? guillaume plantin haresh sapra hyun song shin
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Marking to Market:Panacea or Pandora’s Box?
Guillaume Plantin
Haresh Sapra
Hyun Song Shin
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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
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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
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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.
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“Artificial” Volatility
• Dual role of market price– Reflection of fundamentals – Influences actions
• Reliance on market prices distorts market prices
Actions Prices
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Three Notions of Value
• Fundamental value v
• Book value
• Market price
0v
svp
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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)
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Book Value
• Book value determined by past decisions (exogenous to model)
• Common knowledge at time of decision
• Contractible
0v
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Market Price
• Market price
• Lower ability to extract value
• Limited absorption capacity
svp
)1(
)0(
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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”
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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…
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Duration of Asset
Date 0 Date 1 Date 2
Sell or hold probability dcash flow v
probability 1– dcash flow v
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Date 1 Accounting Values(as seen from decision date)
Hold Sell
01 dvvd
dpvd 1
sv2
historicalcost
mark tomarket
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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
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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
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Global Game
• Firm observes v with small noise
• Take limit as noise tends to zero
• Unique equilibrium– Fundamental uncertainty dissipates but
strategic uncertainty remains
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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)
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• “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*
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• Answer:F(z) = z
• Cumulative distribution function is the identity function
• So, density over s is uniform
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Historical Cost Regime
• Sell when v is high
• Hold when v is low
• Interior solution for intermediate v
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Mark to Market Regime
• Hold when v is high
• Sell when v is low
• Unique equilibrium in switching strategies
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Equilibrium Date 1 Price
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Equilibrium Loss
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Effect of Duration
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Effect of Illiquidity
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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
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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
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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.