Accrual valuation and mark to market adjustment

TL;DR

This paper explores the relationship between accrual and mark-to-market valuation methods for interest rate trades, providing intuitive explanations, mathematical approximations, and practical examples to clarify valuation adjustments.

Contribution

It introduces a Taylor series approximation framework to understand accrual and mark-to-market adjustments, with detailed explanations and a PNL model for interest rate trades.

Findings

Taylor approximation clarifies accrual and mark-to-market effects

Theta and delta are explained within the approximation framework

Deferral concept illustrated with Forward Rate Agreement

Abstract

This paper provides intuition on the relationship of accrual and mark-to-market valuation for cash and forward interest rate trades. Discounted cashflow valuation is compared to spread-based valuation for forward trades, which explains the trader's view on valuation. This is followed by Taylor series approximation for cash trades, uncovering simple intuition behind accrual valuation and mark-to-market adjustment. It is followed by the PNL example modelled in R. Within the Taylor approximation framework, theta and delta are explained. The concept of deferral is explained taking Forward Rate Agreement (FRA) as an example.