Impact-adjusted valuation and the criticality of leverage

Marking whole positions to the current clearing price as in mark-to-market accounting ignores the effect that liquidating a position can have. Such valuations overstate the cash that will be received and underestimate a position’s leverage. Simple parametric models for price impact can capture the effect – and serve as an early warning system against over-leveraging a position, according to Jean-Philippe Bouchaud, Fabio Caccioli and Doyne Farmer

Mark-to-market or ‘fair-value’ accounting is standard industry practice. It consists of assigning a value to a position held in a financial instrument based on the current market clearing price for the relevant instrument or similar instruments. This is commonly justified by the theory of efficient markets, which posits that at any given time market prices faithfully reflect all known information about the value of an asset. However, mark-to-market prices are only marginal prices, reflecting the