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This value, however, might change many times over a day, month, week or year (think of the price of a share, for instance). How do you respond when somebody asks you the value of your investment?
This becomes trickier when you consider that other investments might draw their values from another financial instrument. In this world of geared instruments where slight changes in one instrument might result in big movement in another, market participants need to try and find a way in which to control or limit their exposure to sharp movements.
One of the ways in which to do this is to "mark" the instruments "to market" so that both parties are aware of their obligations at the end of each trading day.
Let us consider two different types of instruments: a single-stock future (SSF) and a warrant, both of which draw their prices from an underlying share (in this case, Sasol).
If Sasol's share price goes up, the SSF or warrant (assuming it is a call warrant) will go up. These movements are typically to a certain geared ratio - that is, if Sasol's share price goes up 1%, the warrant or SSF might go up 10% depending on their gearing.
However these two different types of instruments are priced differently and this means that there are some variations in the pricing of the warrant versus the SSF at the end of a trading day.
A warrant*
A warrant is NOT "marked-to-market" at the end of each day. As a result, the warrant price will not necessarily be valued on a day to day basis at an exact ratio to the underlying share price.
Therefore, when a warrant moves up, the warrant holder does not pay money across as the profit/loss is made.
Exposure is only calculated when the instrument is sold or expires.
An SSF
A SSF, on the other hand, is "marked-to-market" on a daily basis so that all parties involved know their exact exposure to the transaction.
In the case of an SSF, money (margin) will then change hands as a trader makes a gain or loss. This prevents a trader running up an enormous loss and not being able to meet their obligations.
Unit trusts
Unit trusts typically draw their value from the underlying shares that make up their portfolio. The underlying net asset value of the funds under management is calculated at the end of each day to assist in valuing the investment.
In a nutshell, marking an instrument to market means that a market value is assigned to the instrument at a specific time (typically the closing of each trading day) so that an accurate pricing mechanism is in place for traders and investors.
* We acknowledge that this is a generalised description of warrant pricing, but the Fin24.com Jargon Buster series is an educational insert for novices wanting to learn the basics of investing jargon and not necessarily for the sophisticated investors in this space.
- Fin24.com
