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Marking to Market: Panacea or Pandora’s Box?

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

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Marking to Market: Panacea or Pandora’s Box?

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  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 cash flow v Sell or hold Date 0 Date 1 Date 2

  13. Date 1 Accounting Values(as seen from decision date) 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 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)

  18. “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. 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.

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