Bank Treasury: mark to market valuation of derivatives explained

Mark to market valuation of derivatives is the daily discipline that tells a bank what its swap, forward and option book is actually worth today, not what it was booked at on trade date. In a bank treasury, mark to market valuation of derivatives replaces the trade-date price with the current exit price every single day, so an overnight rate move on a single unhedged position shows up in the profit and loss account immediately. For JAIIB and CAIIB candidates, this topic sits at the junction of three syllabus areas: instrument mechanics, valuation mathematics and risk reporting. Examiners like it because it lets them test whether you understand fair value as a process, not just as a definition.

This guide walks through what revaluation measures, how each major instrument is priced off a discount curve, why credit adjustments are layered on top, and how the resulting number drives margin calls, exposure limits and provisioning on client positions.

📉 What Mark to Market Valuation of Derivatives Measures

Fair value is the price at which a position could be closed out with a willing counterparty in an orderly transaction on the reporting date. Revaluation replaces the historical trade price with that current exit price and routes the difference to the profit and loss account or to a reserve, depending on the classification of the deal. Trading positions are revalued and the change is recognised immediately; positions designated as hedges follow the accounting treatment of the underlying, so the gain or loss is deferred or matched rather than taken straight to income.

The contrast to understand is accrual versus fair value. Under accrual accounting, only the interest that has economically arisen during the period is recognised, spread evenly over the life of the contract. Under fair value accounting, the entire remaining life of the contract is repriced every day, so a rate move at the far end of the curve hits today's books even though no cash has changed hands. That is why a bank can report a large derivative loss in a quarter in which every payment was received on time.

A second distinction is realised versus unrealised. Revaluation produces an unrealised figure; it becomes realised only on termination, assignment or maturity. Both are real for risk purposes. Before you can price anything you need a firm grip on how the underlying markets quote, which the chapter on the derivative market covers in detail, and on how dealing desks are organised inside an integrated treasury.

💡 Exam Tip: If a question says "no cash flow has occurred yet", the answer usually involves an unrealised revaluation entry, not a realised gain. Read the wording of the option carefully.

🧮 Valuing Forwards, Swaps and Options Off the Curve

Every derivative valuation reduces to the same three steps: project the future cash flows, discount them to today, and net the two legs. What changes from instrument to instrument is only how the projection is made.

An outright foreign exchange forward is valued by comparing the contracted rate with the forward rate ruling today for the same remaining maturity, and discounting that difference back. If you bought dollars forward at a rate below today's comparable forward rate, the contract carries a positive fair value. An interest rate swap is valued by projecting the floating leg off the forward rates implied by the current swap curve, projecting the fixed leg off the contracted coupon, discounting both legs, and taking the difference. A cross-currency swap adds one more layer, because the two legs sit on two different discount curves and the resulting foreign currency value must be converted at the spot rate; the basis spread between the two currencies is itself a priced input.

The discount curve is therefore the single most important input, and building it correctly demands the same bootstrapping and duration logic taught for fixed income securities, duration and convexity. Candidates preparing the risk paper should also revise the yield curve and term structure of interest rates, because a parallel shift and a steepening produce very different revaluation results on the same swap.

Structures sold to companies, such as currency swaps for corporate hedging, are valued exactly the same way; only the client-facing spread differs.

📊 The CVA and DVA Overlay on Fair Value

A curve-based price assumes both parties always pay. They do not. The credit valuation adjustment, or CVA, reduces the fair value of a position that is in the bank's favour to reflect the chance that the counterparty defaults before the contract matures. It is conceptually the expected loss on the derivative exposure: the profile of expected positive exposure over the life of the deal, multiplied by the counterparty's default probability and by loss given default. Because the exposure profile itself depends on future rates, CVA is a hybrid of market risk and credit risk, and Basel norms as adopted by RBI require capital to be held for the volatility of CVA, not merely for default itself.

The debit valuation adjustment, or DVA, is the mirror image: it recognises that the bank's own credit standing affects what a counterparty would pay to take over the bank's obligations. DVA produces the counter-intuitive result that a deterioration in the bank's own credit can create an accounting gain, which is why many supervisors filter DVA gains out of regulatory capital.

Legal documentation directly reduces the credit overlay. Close-out netting collapses many contracts into a single net amount on default, and a credit support annex requires collateral to be posted as exposure builds, so the residual exposure driving CVA is much smaller. That is why the ISDA master agreement in treasury is treated as a risk-mitigation tool and not merely as paperwork. Similar documentation logic runs through market conventions such as FEDAI rules for forex dealings, which fix value dates and cancellation charges for rupee forward contracts.

⚠️ Common Mistake: CVA is not a provision on an overdue amount. It is an adjustment to the fair value of a live, performing contract, computed on expected future exposure.

🔔 Margin Calls, Credit Equivalent and Client Exposure

Once a revaluation number exists, it drives cash and limits. On exchange-traded and centrally cleared positions, variation margin settles the change in fair value in cash, usually daily, while initial margin is held against the potential move between the last settlement and close-out of a defaulted member. In bilateral deals, a credit support annex performs the same function contractually, with thresholds and minimum transfer amounts deciding when a call is actually made.

For credit limit and capital purposes, current fair value alone understates the risk, because rates can move further tomorrow. Supervisory approaches therefore build a credit equivalent amount out of two parts: the current replacement cost, which is the positive fair value of the contract, and an add-on for potential future exposure that scales with residual maturity and the volatility of the underlying. Negative fair values are floored at zero, since a bank that owes money on a contract has no credit exposure on it. Candidates should confirm the current add-on factors and any netting recognition from the latest RBI master direction, as these have been revised over successive Basel updates.

The same number is what the corporate client sees. A hedge that has moved against the client shows as a mark to market loss on its statement, and where that loss is unsettled and overdue, prudential norms require the bank to treat the receivable as a credit exposure and to provide for it. Unhedged foreign currency exposure of borrowers attracts incremental provisioning and capital under a separate RBI framework, so a client that has left a large exposure open increases the bank's own requirement. Positions in the underlying market itself are covered in the chapter on the foreign exchange market.

📌 Remember: Replacement cost uses the positive fair value only. A contract with a negative fair value contributes nothing to the credit equivalent amount, though it still consumes market risk limits.

🧠 Practice MCQs: Mark to Market Valuation

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❓ Frequently Asked Questions

Treat revaluation as a chain rather than a formula: curve, cash flows, discounting, credit overlay, then limits and provisioning. If you can explain why a swap that has generated no cash yet can still produce a reported loss, and why that loss is scaled down by netting and collateral, you can answer most questions the paper throws at you. Browse more notes on the treasury management tag hub, revise the scope and function of treasury management, and then lock the concepts in with the full CAIIB course and mock tests.

Source and further reading: FIMMDA and the Indian Institute of Banking & Finance.