Mark to Market

Each trading day the exchange establishes a settlement price, typically an average of transactions near the close rather than the last trade, to limit manipulation. The clearinghouse then adjusts every open account: the change in the settlement price, multiplied by the contract multiplier and the number of contracts, is credited to accounts on the profitable side and debited from accounts on the losing side. Cash actually moves, so the clearinghouse's net position remains flat.

A trader posts initial margin as a performance bond before trading and must keep the account above a lower maintenance margin. If losses push the balance below that threshold, a margin call requires a deposit that restores the balance to the initial margin level, not merely back to maintenance. Failure to meet the call allows the broker to liquidate the position, which is why margin is a liquidity commitment rather than a payment for the contract.

Because gains and losses are paid out each day, a futures contract carries no accumulated value into the next session. Its value resets to zero at every settlement, and the position is effectively re-established at the new settlement price. A forward, by contrast, accumulates value between initiation and expiration: it is an asset to one party and a liability to the other, and that exposure is pure counterparty credit risk until settlement.

This mechanical difference explains why futures and forward prices on the same underlying need not be identical. Daily cash flows are reinvested or financed at prevailing short-term rates. When interest rates are positively correlated with the underlying price, the long futures position receives cash when rates are high and pays when rates are low, a modest advantage that pushes futures prices slightly above forward prices. Negative correlation reverses the effect; with no correlation, the two converge.

The same principle governs fair value accounting. Trading assets and most derivatives are carried on the balance sheet at current market value, with a valuation hierarchy running from quoted prices in active markets, through observable inputs for similar instruments, to models relying on unobservable inputs. The lower the level of observability, the greater the scope for judgment, which is why disclosure of the hierarchy matters to analysts assessing earnings quality.

In OTC derivatives, bilateral collateral agreements replicate the exchange model: counterparties revalue positions and exchange variation margin, often daily, so that credit exposure is repeatedly extinguished. Central clearing mandates after the global financial crisis extended this discipline across large parts of the swap market. The practical consequence is that hedgers must fund collateral, which is a cash-flow obligation independent of whether the hedge is economically sound.

Expect to track a margin account through several sessions. Start with the initial deposit, apply the daily gain or loss as the settlement price change times contract size times contracts held, and carry the running balance forward. At each step, test the balance against the maintenance level; if it is breached, add the amount required to return to initial margin and continue from there. Note that a margin call is triggered by the closing balance, and that excess funds above initial margin may generally be withdrawn.

Beyond the arithmetic, be able to explain why daily settlement substitutes liquidity risk for credit risk, why a perfectly hedged economic position can still fail on cash-flow grounds, and why basis or maturity mismatch between the hedge and the exposure determines how severe that funding strain becomes.