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FINANCIAL SECURITIES: MARGIN ACCOUNTS

FINANCIAL SECURITIES: MARGIN ACCOUNTS. CIE 3M1. AGENDA. OPENING A MARGIN ACCOUNT MARGIN ACCOUNTS: A DEFINITION WHAT IS A MARGIN REQUIREMENT? MEETING MARGIN REQUIREMENTS WHAT IS A MARGIN CALL? CALCULATING MARGINS WHY USE MARGINS?. OPENING A MARGIN ACCOUNT.

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FINANCIAL SECURITIES: MARGIN ACCOUNTS

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  1. FINANCIAL SECURITIES: MARGIN ACCOUNTS CIE 3M1

  2. AGENDA • OPENING A MARGIN ACCOUNT • MARGIN ACCOUNTS: A DEFINITION • WHAT IS A MARGIN REQUIREMENT? • MEETING MARGIN REQUIREMENTS • WHAT IS A MARGIN CALL? • CALCULATING MARGINS • WHY USE MARGINS?

  3. OPENING A MARGIN ACCOUNT • Accounts at brokerage firms can be either CASH accounts or MARGIN accounts. • Opening a MARGIN account requires some deposit of CASH or SECURITIES such as T-bills, bonds, other equity securities, etc.

  4. MARGIN ACCOUNTS • Used to purchase additional securities by leveraging the value of the eligible shares to buy more. • Permits investors to borrow money from a brokerage account for personal purposes at the margin interest rate

  5. MARGIN: A DEFINITION • Part of the total value of a sale of securities that a customer must pay to initiate the transaction, with the other part being borrowed from the broker

  6. MARGIN REQUIREMENTS • The amount of funds the investor must personally provide in a margin account. How much depends on LOAN VALUE • CASH has 100% loan value (i.e. $100,000 in cash deposits = $100,000 margin) • Other assets such as STOCKS may have 50% or lower loan value because of the possible fluctuations (changes) in their market value (i.e. you would have to deposit $200,000 worth of common stocks to satisfy a $100,000 margin requirement).

  7. MARGIN REQUIREMENTS • Margin requirements for stocks traded in Canada range from 30% to 100% depending on the price at which the stock is selling. • Margin requirements INCREASE as the stock prices DECREASES. Why??? Because there is ADDITIONAL RISK associated with LOWER PRICED STOCKS!!!

  8. MARGIN REQUIREMENTS

  9. EXAMPLE: MEETING MARGIN REQUIREMENTS • If the margin requirement is 40% on a $100,000 transaction (1000 shares at $100 per share), the customer must put up $40,000 borrowing $60,000 from a broker.

  10. EXAMPLE: MEETING MARGIN REQUIREMENTS • The customer could satisfy their margin requirement by putting up $40,000 in cash or by depositing $80,000 in MARGINABLE securities that qualify for a 50% LOAN VALUE. • For example, deposition 8,000 stocks of XYZ at a market value of $10 each = $80,000 • $80,000 worth of XYZ times 50% loan value = $40,000

  11. REMEMBER! • As stock prices changes, so does investor’s equity! • Investor’s Equity = Market value of COLLATERAL stock minus the amount of money borrowed from the broker • Security firms calculate the actual margin in their customer accounts to see if a “MARGIN CALL” is required.

  12. MARGIN (or MAINTENANCE) CALLS • A demand from the broker for additional cash or securities as a result of the actual margin declining below the margin requirement • Occurs when the market value of the margined securities less the debit balance (amount owed) of the margin account declines below the required margin. • Payable on demand; brokerage house may reserve the right to take action without notice (i.e. may sell enough shares from the margin account to satisfy the margin requirement)

  13. MARGIN (or MAINTENANCE) CALLS • For example, in the previous example the investor deposited 8,000 stocks of XYZ that qualifies for a 50% LOAN VALUE at a market value of $10 each (8,000 x $10 = $80,000) to satisfy a margin requirement of $40,000. • If the market value of stock XYZ decreases to $6 each, then all of a sudden 8,000 x $6 = $48,000 which would only count as $24,000 ($48,000 x 50% LOAN VALUE) towards the margin requirement of $40,000. Therefore the investor would no longer be covering the margin requirement and the broker would have to make a MARGIN CALL for $16,000 to make up for the shortfall.

  14. MARGIN (or MAINTENANCE) CALLS • If the market value of stock XYZ decreases to $6 each, then all of a sudden 8,000 x $6 = $48,000 which would only count as $24,000 ($48,000 x 50% LOAN VALUE) towards the margin requirement of $40,000. Therefore, the investor would no longer be covering the margin requirement and the broker would have to make a MARGIN CALL for $16,000 to make up for the shortfall.

  15. MARGIN (or MAINTENANCE) CALLS • If the investor’s equity EXCEEDS the required margin (i.e. the COLLATERAL stock price increases), the investor can withdraw the EXCESS MARGIN or use it to buy more stock

  16. MARGIN (or MAINTENANCE) CALLS • For example, in the previous example the investor deposited 8,000 stocks of XYZ at a market value of $10 each (8,000 x $10 = $80,000 that qualify for a 50% LOAN VALUE) to satisfy a margin requirement of $40,000.

  17. MARGIN (or MAINTENANCE) CALLS • If the market value of stock XYZ increases to $15 each, then all of a sudden 8,000 x $15 = $120,000 which would count as $60,000 ($120,000 x 50% LOAN VALUE) towards the margin requirement of $40,000. Therefore the investor’s equity would EXCEED the required margin by $20,000 which he/she can withdraw or use to buy more stock.

  18. CALCULATING MARGIN • Say that a margin account requires a margin of 40% and the price of 1,000 shares of stock XYZ drops from $100 to $90 per share (60% borrowed from broker). • ACTUAL MARGIN = MARKET VALUE OF SECURITIES – AMOUNT BORROWED MARKET VALUE OF SECURITIES = $90,000 - $60,000 $90,000 = 33.33% • Obviously 33.33% does not match the 40% original margin requirement; the investor would receive a MARGIN CALL but for how much???

  19. CALCULATING MARGIN • The investor should have an equity position of 40% of $90,000 (= $36,000) and the broker’s maximum loan value is only 60% of $90,000 (=$54,000). • Therefore, to restore the appropriate margin, the investor could contribute $6,000 which would reduce the loan from $60,000 to the required $54,000 and increase the equity position from $30,000 to $36,000.

  20. WHY USE MARGINS? • Because they magnify any gains on a transaction by the RECIPROCAL of the margin requirement (1/margin percentage) • BUT margin accounts also magnify any losses on a transaction

  21. AN EXAMPLE • TYPICAL CASE: Joe buys 1000 shares of XYZ at $10 each ($10,000 total). If the stock increases (decreases) to $12 ($8), he stands to gain (lose) $2,000 or 20% on his initial investment • MARGIN CASE: Jane buys 1000 shares of XYZ at $10 each but on MARGIN at the 40% margin rate. Jane’s initial investment was $4,000 (40% of the $10,000 total cost). If the stock increases (decreases) to $12 (to $8), she still stands to gain (lose) $2,000 like Joe BUT Jane’s original cash outlay was only $4,000 so the investor’s gain (loss) is 2.5 times greater at 40% of the original investment (or 1/0.4)

  22. REMEMBER! • REMEMBER, the margin trader must pay the interest costs on the margin account (i.e. the margin interest rate = prime lending rate plus a percentage added by broker) • The stock price must rise and cover the cost of the margin interest rate before an investor can make a profit!

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