Consistency with trading strategy

Valuation and accounting policies are intimately linked. Many of the examples below
may seem rather detailed but they can lead to big swings in reported profits and
have often taken up many hours which could be used for other work.
There are some businesses where the rule that all instruments should be valued
using market rates causes complications. For example, arbitrage businesses would
never show any profit until the market moved back into line or the instruments
expired. Given the history of supposedly arbitraged trading strategies resulting in
large losses, this may not be regarded by senior management as a particular problem,
but the theory is worth thinking through.
If exactly the same instrument can be bought in one situation for a price lower
than it can be sold in another, then the rational action is to buy it at the lower price
and sell at the higher. As the instrument is exactly the same, the net position will be
zero, and there will be a positive cash balance representing the profit.
If the two instruments are very similar, and react in the same way to changes in
underlying prices, but are not quite identical then it still makes sense to buy at the
lower price and sell at the higher one. However, this time the instrument positions
will not net off and if prices have not moved, the difference between the values of the
positions will be exactly the opposite of the cash received, so the net profit will be
reported as zero. Eventually the market prices of the two instruments will become
closer, or they will turn into identical offsetting amounts of cash (or the strategy will
be shown not to be a perfect arbitrage!) and the profit will be recognized. Indeed in
the time before expiry it is possible that the prices will move further apart from
equality and a loss will be reported. This is not popular with traders who want to be
able to report that they have locked in a ‘risk-free’ profit with their trading at
inception.
A theoretical example of such a situation would be where an OTC instrument is
identical to the sum of two or more listed instruments. The listed instruments can
be valued at market prices. If the OTC valuation model uses inputs such as implied
volatility derived from other listed instruments and the market prices of the various
listed instruments are inconsistent, then we will end up with a profit/loss being
reported when it is certain that none will be eventually realized. This is a good
illustration that markets are not always perfect, and that accounts based on marking
to market may also not be perfect. It is easy to suggest that human judgement should
be left to identify and correct such situations, but once one introduces the potential
for judgement to override policy, there is a danger that its application becomes too
common, thus reducing the objectivity of reports.
Such considerations often lead to trading desks seeking to ensure that their
positions are valued using a basis which is internally consistent to reduce ‘noise’ in
the reported profit. However, for different trading desks to value the same instrument
differently causes great problems for central accounting functions which may be
faced with values which are supposed to net off, but do not do so. The benefit of
smoothing within a trading desk is usually obtained at the cost of introducing
inconsistency for group reporting.
A particular case where instruments may be valued differently without either
trading desk even seeing that there might be a problem is in options on interest rate
instruments. In some situations the underlying may be regarded as the price of a
bond, while in others it may be the yield on a bond. Most option valuation methodologies
require the assumption that the distribution of the underlying is log-normal.
As price and yield are more or less reciprocal, it is not possible for both of them to
be log-normal, and indeed different values will be obtained from two such systems
for the same instrument.
Valuing all the listed instruments involved using market prices rather than theoretical
prices is the correct approach. The reason why this can be said to have
accounting risk is that the reporting of the loss may lead senior management to
order a liquidation of the positions, which will definitely crystalize that loss, when
holding the instruments to maturity would have resulted in a profit. While there is
much dispute in the academic and business community, this is arguably at least
part of what happened at Metallgesellschaft in 1993. 482