1. Marking to Market: Panacea or Pandora’s Box?
Guillaume Plantin
Haresh Sapra
Hyun Song Shin

2. 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

3. 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

4. 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.

5. “Artificial” Volatility
Dual role of market price
Reflection of fundamentals
Influences actions
Reliance on market prices distorts market prices
Prices
Actions

6. Three Notions of Value
Fundamental value v
Book value
Market price

7. 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)

8. Book Value
Book value determined by past decisions (exogenous to model)
Common knowledge at time of decision
Contractible

9. Market Price Market price Lower ability to extract value
Limited absorption capacity

10. 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”

11. 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…

12. Duration of Asset probability 1– d cash flow v probability d
Sell or hold
Date 0
Date 1
Date 2

13. Date 1 Accounting Values (as seen from decision date)
Hold
Sell
historical
cost
mark to
market

14. 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

15. 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

16. Global Game Firm observes v with small noise
Take limit as noise tends to zero
Unique equilibrium
Fundamental uncertainty dissipates but strategic uncertainty remains

17. 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)

18. “I am the marginal player
“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*

19. Cumulative distribution function is the identity function
Answer:
F(z) = z
Cumulative distribution function is the identity function
So, density over s is uniform

20. Historical Cost Regime
Sell when v is high
Hold when v is low
Interior solution for intermediate v

21. Mark to Market Regime Hold when v is high Sell when v is low
Unique equilibrium in switching strategies

22. Equilibrium Date 1 Price

23. Equilibrium Loss

24. Effect of Duration

25. Effect of Illiquidity

26. 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

27. 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

28. 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.