Mark to model

In normal circumstances, securities such as shares or bonds are valued by using market prices: a share in Acme Widgets sold for £1.50, so your holding of Acme Widgets in your portfolio should be valued at that price. This valuation method is called ‘mark to market’.

But in situations where the securities are rarely traded and there are no recent reference prices, valuing your holdings may be more difficult. So these investments may be valued in alternatives ways that use internal pricing models or assumptions, a process known as “mark to model”.

Typically the type of assets that are valued using this technique are complex derivatives contracts and securitised debt instruments. The sub-prime mortgage crisis in 2007 highlighted the problem with mark to model, in that valuations based on models and assumptions can be wildly incorrect: default rates proved higher than expected and holders of these securities ultimately had to write off tens of billions of dollars.

A second problem is that even if valuations are accurate, it may be difficult to sell illiquid securities quickly at a fair price, so marked-to-model portfolios can give a false impression of how much can be raised in a fast sale.

Merryn

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