Handbook of Asset and Liability Management: From models to optimal return strategies

4

“Accrued Accounting” for Interest Rate Instruments Versus “Marked-to-Market” Accounting

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4.1 GENERAL PRINCIPLES

“Accrued accounting” may be seen as the opposite of “marked-to-market accounting”.

“Marked-to-market accounting” refers to a way of measuring products at a fair value price, i.e. at an observable quoted price or at a computed selling price. The P&L (profit and loss) associated with the product on a single day period is the simple difference between the two marked-to-market.

For example, consider a government bond bought at par at date t for a nominal amount of 100 with an annual coupon of 5% (paid at date t+1). In those conditions, the disbursed amount is of 100 as well.

On date t+1, the government bond market price is of 101.

The P&L associated with the Bond for the period [t; t+1] will be of 6:

• 1 for the market price move from 100 to 101;
• 5 for the coupon paid on t+1.

Of course, each product has to be refinanced. Here comes the notion of P&L net of carry (i.e. free of cost of carry). The whole balance sheet is well balanced. The assets total is equal to the liabilities total. To represent a P&L and to take into account this necessary equilibrium, the P&L free of cost of carry subtracts the cost of the mobilized cash on the period to the simple P&L.

In our example, if the cost of cash on the period [t; t+1] was of 4% (the average capitalized DD rate on the period plus the liquidity company cost), the marked-to-market P&L free ...