Forward learning curve
The learning curve was steep, first to get used to the jargon of options, second to get used to the culture of mark-to-market.
In normal (accrual-based) accounting, the value of what you have depends on how much it cost you to buy it. You depreciate the fixed assets by a certain percentage per year, commensurate with utilisation.
Many people still go by this rule. They think what they are worth is what they need to recoup to cover the amount of money they had spent on their education. But in reality, what you're worth depends on how much someone else is willing to pay for you.
This willingness to pay reflects the perception in the market, much like the stock price. It's a synthesis of all the perceived values, however accurate or wrong, by the interested parties.
If you mark your asset to the market, then it's only worth what the market will pay on that day.
In the heart of mark-to-market accounting lies the treasured forward (price) curves which the traders set each day. A forward curve shows what someone is willing to pay today for the "forward" delivery of some good. "Forward" means sometime in the future.
A forward curve of your worth might be what you think you can command, by way of salary, today, tomorrow, a month from now, and a year from now at the rate you are progressing today. However, suppose an unforeseen accident disables you next month, your forward salary curve will look very different from the one you fix today.
It's not surprising that many people get forward price curves and forecast prices mixed up. A forecast of prices shows how prices may move over time. There is no "willingness to transact" property in this. A forecast of your salary will of course change, depending on when you make the forecast. Both forward curves and forecasts depend on the time at which they are created. But the main difference is that the first one has a "transaction" element while the other is more passive.
Forward curves are used in mark-to-market valuations as well as risk assessments. So they are a heavily guarded asset. There may be hundreds or even thousands of forward curves as prices are defined by the markets they serve. And markets are defined by location and time. Interest rates are prices that reflect the value of money over time. Similarly, exchange rates are prices that reflect the value of one currency against another.
Are forward prices subjective? Well, the traders set them. And they are out to make money. Since they're the ones who do the trades, they must know the market. You have to know the market to be able to set the curves. So how do you validate their curves if you're not a trader in the same market yourself?
It's not at all surprising that counterparties on both sides of the deal can book the same deal as profitable to both, using different forward curves. But in trading, like other zero-sum games, how can you have the buyer and the seller make money on the same trade on the same day?
14 December 2001 Friday