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Describe how marking to market is applied to futures, along with hedge accounting.

FRM® Part I · Financial Markets and Products · Futures Markets · FRM1.FM.7.f

The idea

Marking to market means a futures position is revalued every day at the settlement price, and the gain or loss is moved into or out of the margin account that day. A long gains when the settlement price rises, and a short gains when it falls. The investor posts initial margin. If the balance drops below the maintenance level, a margin call requires a deposit of variation margin that restores the account to the initial margin level, not just to maintenance. For a long, cumulative daily settlements equal the final price − the entry price. Hedge accounting lets the gain or loss on a designated, documented hedging instrument be recognised in earnings in the same period as the hedged item. This reduces earnings volatility. Without it, futures gains and losses hit earnings as they arise.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does marking to market mean for a futures position?

  1. Gains and losses are accumulated and paid only at expiry or when the position is closed.Why not: Describes forward-style settlement; futures are settled daily.
  2. The margin account is revalued only when a margin call occurs.Why not: Revaluation is daily and does not depend on a margin call.
  3. Each day's gain or loss, based on the settlement price, is moved through the margin account. - correct
  4. The futures price is reset each day to equal the spot price.Why not: Marking to market does not change the contract's pricing; it settles the day's change in value.

Marking to market settles the day's change in the futures settlement price through the margin account, so gains and losses are realised daily.

A harder one

A company expects to sell oil next year and shorts futures. At year-end, the price has risen and the futures show a loss of USD 300,000. Which statement about reported earnings is correct?

  1. With hedge accounting the loss is deferred until the forecast sale affects earnings; without it, the loss is in current-year earnings. - correct
  2. With hedge accounting the loss is recognised now; without it, the loss is deferred.Why not: Reverses the effect; hedge accounting is what allows deferral.
  3. The treatment is the same in both cases because the loss was settled in cash through margin.Why not: Accounting recognition does not follow cash timing.
  4. With hedge accounting the loss is recognised now, together with the unrealised gain on the expected sale.Why not: Gains on a forecast sale are not recognised in advance; hedge accounting only defers the hedge result.

Under hedge accounting the effective portion of the loss is held back until the hedged sale affects earnings. Without it, the futures loss hits current earnings immediately.

The hardest tier

A trader is short 20 contracts (5,000 bushels each) from 6.20. Initial margin is USD 2,500 per contract and maintenance is USD 2,000. Settlement prices are 6.23, 6.26, 6.31 and 6.17 over four days. Margin calls restore the initial margin level. What is the margin balance at the end of day 4, before any withdrawal?

  1. USD 53,000Why not: Omits the USD 11,000 deposit made after the day-3 margin call.
  2. USD 64,000 - correct
  3. USD 54,000Why not: Restores the account only to maintenance (USD 40,000) after the call instead of to initial margin.
  4. USD 47,000Why not: Treats price rises as gains for the short and the day-4 fall as a loss, reversing every sign.

Start 50,000; day 1 -3,000 = 47,000; day 2 -3,000 = 44,000; day 3 -5,000 = 39,000 (below 40,000) so deposit 11,000 to reach 50,000; day 4 +14,000 = 64,000.

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