Even wonder how hedge funds figure out how well they’re doing? Hedge fund investments are revalued at the end of each trading day, as part of the daily calculation of profits and losses (P&L). Mark-to-market (MTM) is an accounting treatment that records the price or value of a security, portfolio or account to reflect its current market value rather than its book value. MTM P&L measures how much one pays to buy a financial instrument versus how much one receives to sell it. If the position is long, the position owner purchases the security first and later sells it. In a short position, the position owner borrows and sells the security first and later repurchases it. In either case, the position owner will realize a gain or loss on the trading activity when the position is closed. While a position is still open, the owner’s gain or loss is “on paper” only. This is termed an unrealized profit or loss. Price changes in the market affect unrealized P&L.
Keeping track of all the information necessary to calculate and report MTM P&L requires detail record keeping. A tax lot is the fundamental cost accounting unit for the trading of securities. A tax lot represents the purchase or sale of a specific quantity of a particular instrument at a specified time and price. Tax-lot accounting is a record-keeping technique that traces the dates of purchase and sale, cost basis, and transaction size for each security in a portfolio. Tax lots are usually ordered in first in, first out sequence (FIFO tax lot).
Tax lots are recorded as transactions in the books of a trading entity. Transactions record trading activity and other financial events, such as interest and dividend payments, conversions, transfers, repos, loans and borrows, and portfolio-related expenses and revenue. The transaction type of a transaction reflects the kind of activity represented; the types relevant to MTM P&L include purchases, sales, and conversions.
Posting is the process of recording a transaction in a company’s books. In an automated trade accounting system, a transaction is automatically assigned a unique transaction key upon posting. Each company is free to set up its transaction key format as it sees fit. The first in first out (FIFO) sequencing of posted transactions depends upon the values of certain fields within the transactions defining the tax lots.
The cost basis per unit of a tax lot is the net settlement amount paid or received by the transaction (excluding accrued interest), divided by the quantity of units (shares, bonds, etc.) in the transaction. Any trade-related costs, including commissions and transfer taxes, are included in the tax lot cost basis.
For example, in the purchase of 100 shares of XYZ Corp at $50.10 per share (including commissions), the cost basis per share is $50.10, and the net settlement amount is $5,010.
The unit price assigned to the local tax lot is in the local trading currency of the instrument. The dollar cost of the tax lot is the local cost multiplied by the foreign exchange rate on the settle date of the trade. The tax lot cost basis is a permanent attribute of the tax lot which is established at the time the tax lot is opened.
A tax lot is said to be open when a trade is first put on. That is, an open tax lot is represented by an initial purchase or sale transaction. The quantity associated with an open tax lot represents the excess of purchases over sales for a long position, or the excess of sales over purchases for a short position. As a position holder subsequently disposes of the open position, transactions are recorded that partially or fully close the tax lot. A closed tax lot has offsetting quantities of purchased and sold securities (i.e. the net quantity of a closed tax lot is zero).
In my next article in this series, I’ll explore positions, realized and unrealized P&L, and P&L aggregation by strategy.
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Copyright 2014 Eric Bank, Freelance Writer