FIN3244 Exam 3 Study Guide This study guide includes the end of chapter 8 9 and 11 Chapter 8 Markets and transactions margin trading Trading on margin 1 Leverage the use of borrowed funds to buy securities 2 Margin the percentage of an investors equity a Example an investor makes a 1000 investment using 750 of his money and 250 borrowed He is using leverage because he is borrowing money to purchase bonds and the margin in his account is 75 because 75 of the invested money was his investors money investors money borrowed money margin 3 Margin is the collateral for a broker s loan a Can be cash or acceptable securities stock bonds mutual funds or derivatives 4 Portfolio a group of financial securities a Portfolio s value sum of its individual holdings b Example value of stock 1 value of stock 2 value of stock 3 c Remember if you have a lot of a stock need to multiply the number of them you have by the value of them Because the price changes the value of a portfolio will change too And because this is the collateral the value of the margin an investor has in something will change with it Why trade on margin 1 Because it magnifies gains it increases the size of your returns But this also means that it could magnify losses a If you have 500 to invest and you want to buy a stock that is 50 a share i If you don t trade on margin you can buy 100 That is if you use just your money you can get 100 shares If you trade on 50 margin you can use your 5000 to borrow another 5000 and you can buy 200 shares of stock ii iii So if you have 100 shares and the price goes up by 5 you ve made 500 but if you have 200 shares you ve made 1000 So you re magnifying your gains by 2 2 Buying on margin a Advantage i magnifies profits b Disadvantages i Magnifies losses ii Interest paid on margin loan You re borrowing money so there s a cost to doing that iii Possible margin calls 3 Rules a Must have a margin account with broker i 2000 equity of 100 of purchase price whichever is smaller ii Let s you borrow from brokerage for investments iii Securities kept by broker until loan is repaid These securities are the collateral for the money that you borrowed They will not release these or the money made off of them until their loan is repaid iv Let s brokerage safeguard the money it lent to you If the value of the stock gets too low you will not have sufficient margin or equity in your account as collateral for the loan The broker will generally give you a margin call at this time which will allow you to add money or other securities from other accounts to bring the value of your margin in your account back up to where you need it to be If you don t do this than the broker will sell sufficient securities in your account to cover the cost of the loan that you have with them Sometimes when stocks are dropping too rapidly they will not give you the curtesy of a margin call b Margin of investors equity c Minimum margin requirement set by the Fed The least amount of margin that you can have in your account when you buy stock Brokers cannot reduce the minimum past this i This depends on securities risk The Fed sets it at 50 for stocks and 30 for bonds The less margin there is in the account the less collateral you have for the loan and the riskier the loan is Bonds are generally safer investments than the stock so the minimum can be lower The brokerage can require that you have more margin but this is the minimum ii OTC stocks can t be margined they have no collateral value because they are so risky Types of margin 1 Initial margin minimum equity an investor must have in his account either the minimum margin requirement or a higher requirement the brokerage firm has determined at the time you purchase shares of stock 2 Maintenance margin minimum equity an investor must have in his account at all times This will be a lower percentage of margin in your account than the initial margin 3 Margin call notice that equity in an account is below the maintenance margin a Must be returned to maintenance margin level usually have 3 business days your permission b Or account holdings are sold to bring it back up They can do this without 4 Restricted margin account equity is below initial margin required but higher than maintenance margin Because it s lower than the initial margin you can t make any purchases until your account gets back up to the initial margin requirement Example Joe bought 100 shares at 24 a share He used his 70 initial margin account to make the purchase He sold them after a year for 20 a share Ignoring costs what is the new margin in his account o The value of an account equity debt VI EI D these have a subscript I because the value will change o V of shares X price per share in dollars 100 X 24 2400 this is the value when he initially bought it o His initial margin was 70 so 70 of the 2400 is 1680 So 1680 of the 2400 was originally his Therefore the difference 720 the remaining 30 was borrowed Although the value and equity will change the debt will stay the same The value of the stock could go up or down but Joe has borrowed 720 and he still owes them 720 o Now the stock price has changed to 20 100 X 20 2000 To figure out what the new equity in his account is we know the value of the account is 2000 and he still owes 720 Therefore we can subtract to find the equity V D E 2000 720 1280 He has 1280 of equity in his account but margin is a percentage To find this we take the current equity which was V D and we divide it by the current value This would be 2000 720 2000 64 The price of the stock went down and so did the amount of equity in his account Margin will move in the same direction the stock price moves Noteworthy o Trading on margin has no impact on stock price direction o The amount of margin in an account moves in the same direction as the value of the stock portfolio moves o The more stock shares you hold the greater the dollar return gain or loss It doesn t matter where the money to buy the stock came from whether its borrowed or not o The smaller portion of investors funds used the greater the rate of return gain or loss The return is based on the amount of the investor s personal funds …
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