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In: Finance

Discuss marking to market and margin accounts in the futures market. Your answer should include a...

Discuss marking to market and margin accounts in the futures market. Your answer should include a description of margin calls.

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Expert Solution

Mark To Market - Definition
In futures trading, it is the process of valuing assets covered in a futures contract at the end of each trading day and then profit and loss is settled between the long and the short.
As mentioned above, Mark-To-Market or "Marking To Market" isn't an exclusive futures trading term. It is a term which is used in finance to describe how assets are being priced based on the value that is given on it by the open market instead of considering its true intrinsic value. Indeed, this procedure has contributed to the 2008 subprime crisis as illiquid assets are priced to markets that really don't exist.
In futures trading, Marking To Market is also known as "Daily Settlement". This is a procedure conducted by the clearinghouse daily which determines the value for the asset covered by the futures contracts, known as the "Settlement Price", and then convert the paper gains and losses to actual gains and losses in the accounts of the parties involved.
Marked to Market (MTM) is a margin that is collected from a stockbroker over and above the regular initial margin if a trader wishes to carry a position to the next day under the circumstances that the closing price is not in favour of the trader. This margin is specific to Derivative Segment of both equity and commodities market and particularly for Futures Trading.
Example
For example, you have taken a Long Position in the Futures Market of Infosys stock of one lot comprising of 500 shares at Rs.1000 per share with the total contact value of Rs.5.00 lakh and have paid Rs.50000 as your initial margin at 10% of the contract value. At the end of the day at about 3.30 pm (just before the market is closing) if the price of Infosys is trading at Rs.990 the broker may ask you to pay the difference between the price you bought and the closing price (Rs.1000 - Rs.990) which will be Rs.10 x 500 shares = Rs.5000 to carry the position to the next day. That Rs.5000 is MTM.
Margin call
A margin call is a broker's demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when the account value depresses to a value calculated by the broker's particular formula.
An investor receives a margin call from a broker if one or more of the securities he had bought with borrowed money decreases in value past a certain point. The investor must either deposit more money in the account or sell off some of his assets.
Consider an investor who buys $100,000 of stocks by using $50,000 of his own funds and borrowing the remaining $50,000 from his broker. The investor's broker has a maintenance margin of 25% with which the investor must comply. At the time of purchase, the investor's equity is $50,000 (the market value of securities of $100,000 minus the broker's loan of $50,000), and the equity as a percent of the total market value of securities is 50% (the equity of $50,000 divided by the total market value of securities of $100,000), which is above the maintenance margin of 25%.
Suppose that on the second trading day, the value of the purchased securities falls to $60,000. This results in the investor's equity of $10,000 (the market value of $60,000 minus the borrowed funds of $50,000). However, the investor must maintain at least $15,000 of equity (the market value of securities of $60,000 times the 25% maintenance margin) in his account to be eligible for margin, resulting in a $5,000 deficiency. The broker makes a margin call, requiring the investor to deposit at least $5,000 in cash to meet the maintenance margin. If the investor does not deposit $5,000 in a timely manner, his broker can liquidate securities for the value sufficient to bring his account in compliance with maintenance margin rules.

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