FIN3244 Exam 3 Study Guide Chapter 2 Long Purchase and can be sold at a later date for profit a transaction in which investors buy securities in the hope that they will increase in value o Object is to buy low and sell high o o o Long purchases are the most common type of transaction Investors expect the price to rise Returns come from dividends interest current income plus capital gains losses Margin Trading the use of borrowed funds to buy securities o o Trading on margin is used to magnify returns Margin refers to the percent of the investment not borrowed investor s own funds For example 75 margin means that the investor used his own funds to finance 75 of the transaction Brokers must approve margin purchases o o When purchasing a security on margin the brokerage firm lends the purchaser the needed funds and retains the purchased securities as collateral The purchaser must pay a specified rate of interest on the borrowed funds requirements set by the Fed specifying the minimum amount of equity that o Margin Requirement must be the investor s own funds Margin requirement for stock is 50 By raising or lowering the margin requirement the Fed can depress or stimulate activity in securities markets o Biggest risk of margin trading is that it can only magnify returns not create them and it also magnifies losses o Margin trading not normally used to buy tax exempt municipal bonds because the interest paid o on marginal loans is not deductible for income tax purposes It is also possible to use margin on certain foreign stocks and bonds that meet the prescribed criteria and appear on the Fed s List of Foreign Margin Stocks Leverage o o When marginally trading as the margin decreases the rates of return increase accordingly the use of debt financing to magnify investment returns Size of the magnified return depends on both the price behavior of the security and the amount of margin used o o o o Margin Loan Another more modest benefit of margin trading is that it allows for greater diversification Two key disadvantages of margin trading are 1 magnified losses and 2 the cost of the margin loans themselves in a margin transaction The interest rate of a margin loan depends on prevailing market rates and the amount of money being borrowed vehicle through which borrowed funds are made available at a stated interest rate The interest rate on margin loans is usually 1 to 3 above the prime rate Prime Rate the lowest interest rate charged to the best business borrowers o Margin Account a brokerage account for which margin trading is authorized Requirements for a margin account are a minimum of 2000 in equity or 100 of the purchase price whichever is less in the form of either cash or securities o o o It is not unusual for brokerage firms and the major exchanges to establish their own margin requirements higher than the Fed s Two types of margin requirements are 1 initial margin and 2 maintenance margin Initial Margin of the purchase the minimum amount of equity that must be provided by the investor at the time Prevents overtrading and excessive speculation All securities have specific initial requirements more stable investment vehicles usually have lower margin requirements o OTC stocks are considered to have no collateral value and therefore cannot be margined If the value of the investor s holdings decline the margin in their account will also drop o accordingly Restricted Account an account whose equity is less than the initial margin requirement o Consequences are that the investor may not make further margin purchases and must bring the margin back to the initial level when the securities are sold the absolute minimum amount of margin that an investor must maintain in o Maintenance Margin the margin account at all times Maintenance margin on equities securities is 25 For straight debt securities there is no official maintenance margin except that set by the brokerage firms themselves If the account falls below the maintenance margin the investor will receive a margin call o Margin Call margined holdings sold to reach this standard notification to bring equity back to the maintenance margin or have enough If the margin call doesn t work the broker is authorized to sell enough of the investor s margined holdings to bring the equity back up to the standard o Two pieces of information required for the margin formula are 1 the prevailing market value of the securities being margined and 2 the debit balance Debit balance the amount of money being borrowed in the margin loan o Margin Formula Value of Securities Debit Balance Value of Securities Same formula is used for multiple security accounts except margin applies to the account as a whole the value of all securities held in the account and the total amount of margin loans o o o ROI formula Total current Total interest paid Market Value of Market value of Income received on margin loan securities at sale securities at purch Amount of equity at purchase Can be used to calculate either the expected or the actual return the techniques of using paper profits in margin accounts to partly or fully finance the Pyramiding acquisition of additional securities Allows investors to make transactions at margins below prevailing initial margin levels and to buy securities with no new cash at all Excess Margin more equity than is required in a margin account Through pyramiding the investor can purchase new securities with no new cash at all because paper profits in the account lead to excess margin Only constraint is that when the additional securities are purchased your margin account must be at or above the required initial margin level o When trading marginally it is the account as a whole not the individual transactions that must meet the minimum standards Short Selling return to the lender the sale of borrowed securities their eventual repurchase by the short seller and their In practice short selling is limited almost exclusively to common stocks and options Short selling starts when an investor borrows securities from a broker and then sells those securities in the market o When the price of the issue has declined the short seller then buys back the securities and returns them to the lender Short seller must make an initial equity deposit with the broker This deposit plus proceeds from the sale of the borrowed shares assures the broker that sufficient funds are available to buy back the shorted securities even if their price increases Short sellers
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