FIN3244 Chapter 8 Margin Trading Short Selling Trading on a Margin Margin trading using borrowed funds to purchase securities Used for one basic reason magnifying returns Margin the amount of equity stated as a percentage in an investment or the amount that is NOT borrowed 75 margin means 75 of the investment is being financed with the investor s own funds and the balance 25 with borrowed money Margin requirement set by the Federal Reserve specifies the minimum amount of equity that must be the margin investor s own funds requirement for stocks has been 50 for a long time Lowering raising the requirement allows the Fed to depress or stimulate activity in the securities market Example of a margin transaction You want to purchase 70 shares of common stock which is selling for 63 50 per share With a margin requirement of 50 you need to put up only 2 222 50 in cash 63 50 per share x 70 shares x 50 Your brokerage firm will lend you the remaining 2 222 50 You still have to pay interest on the amount you borrow plus any brokerage fees With the use of margin you can purchase more securities than you could on a cash basis magnifying your there is still increased risk if the stock doesn t perform well the loss is magnified returns Essentials of Margin Trading Investors can use margin trading on most kinds of securities common preferred stocks most types of bonds mutual funds options warrants and futures not used with tax exempt municipal bonds because the interest paid on such margin loans is not deductible for income tax purposes Magnified profits and losses Financial leverage the use of debt financing to magnify investment returns The price of the stock will move in whatever way it is going to no matter how the position is fi nanced The lower the amount of the investor s equity in the position the greater the rate of return the in vestor will enjoy when the price of the security rises The loss is also magnified by the same rate when the price of the security falls Advantages and Disadvantages of Margin Trading Advantages a magnified return size of magnified return depends on both the price behavior of the security and the amount of margin used Allows for greater diversification of security holdings because investors can spread their limited capital over a larger number of investments Disadvantages potential for magnified losses Cost of margin loans Margin loan the official vehicle through which the borrowed funds are made available in a margin transaction made at a stated interest rate which depends on market rates and the amount of money being borrowed Prime rate the interest rate charged to creditworthy business borrowers The rate is usually 1 3 above the prime rate The loan cost will increase daily reducing the level of profit Making Margin Transactions To execute a margin transaction an investor must establish a margin account with a minimum of 2000 in equity or 100 of the purchase price whichever is less in the form of cash or securities the broker will retain any securities purchased on margin as collateral for the loan The Fed establishes the margin requirement which is the minimum amount of equity for margin transactions Initial margin the minimum amount of equity that must be provided by the investor at the time of purchase prevents overtrading and excessive speculation OTC stocks are considered to have no collateral value and can not be margined As long as the margin in an account remains at a level equal or higher than prevailing initial requirements the investor may use the account in any way he or she wants if the value of the investor s holdings declines the margin in their account also drops which will lead to a restricted account Restricted account an account in which equity is less than the initial margin requirement does not mean that the investor must put up additional cash or equity as long as the account is restricted the investor may not make further margin purchases and must bring the margin back to the initial level when securities are sold Maintenance margin the absolute minimum amounts of margin equity that an investor must maintain the the margin account at all times Margin call when an insufficient amount of maintenance margin exists the investor is called and gives the investor a short period of time to bring the equity up to the maintenance level or the bro ker is authorized to sell enough of the investor s margined holdings to bring the equity in the ac count up protects both the broker and the investor brokers avoid having to absorb excessive in vestor losses and investors avoid being wiped out Maintenance margin is currently 25 and rarely changes Debt securities government bonds have no official maintenance margin except that set by the brokerage firm themselves The Basic Margin Formula The amount of margin is always measured in terms of its relative amount of equity which is considered the investor s collateral A simple formula can be used to determine the amount of margin in the transaction The prevailing value of the securities being margined is needed The debit balance the amount of money being borrowed in the margin loan is needed Formula Margin Value of Securities Debit Balance Value of Securities V D V Formula in Action Assume you want to purchase 100 shares of stock at 40 a share Initial margin requirement is 70 70 of the transaction must be financed with equity You will borrow 30 x 4000 or 1200 debit balance The remaining 4000 1200 2800 represents your equity in the transaction in other words equity is represented by V D What happens to the margin as the value of the security changes If the stock moves to 65 then Margin V D V 6500 1200 6500 815 81 5 the margin equity in this investment position has risen from 70 to 81 5 when the price of the security goes up your margin also goes up Return on Invested Capital When assessing the return on margin transactions you must take into account that you only put up part of the funds therefore you are concerned with the rate of return earned on only the portion of the funds that you provided we can do this using both current income received from dividends or interest and total in terest paid on the margin loan return on invested capital from a margin transaction Total current income received Total interest paid on margin loan Market value of securities at sale Market value of securities at purchase Amount of equity at purchase Noteworthy Items about Margin Trading Trading on a margin does NOT impact stock
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