Lesson 2 of 10
An investor who wants to take a position in a stock but doesn't have enough funds can use borrowed funds to purchase the asset. This is called a leveraged position, and the investor is said to be using leverage. One of the ways to use borrowed funds is called margin loan. Let's look at how it works.
To purchase an asset on margin, an investor can borrow funds from his broker. This is called a margin loan. The investor usually pays an interest on this loan which is called the call money rate.
No broker will allow an asset to be fully financed. The investor will have to provide a minimum amount of equity, called the initial margin requirement. For example, a 50% initial margin requirement means that for an asset worth $100, $50 of equity should be provided by the investor, and the remaining $50 will be provided as margin loan by the broker. This is also called financial leverage and it adds additional risk to the investor portfolio. Let’s look at the dynamics of a margin transaction.
Let’s assume that an investor buys 100 shares of a stock at $100 per share. The initial margin requirement is 50%, that means the investor has to provide an initial equity of 5,000, i.e., 50% of total money required to purchase the stocks. We’ve assumed that there is no transaction cost.
Suppose the stock price increases to $120 after one year. The gain on stock is $2,000. The investor also receives a dividend of $200. Since half of the transaction is on margin money, the investor has to pay interest on these borrowed funds to the broker. Assuming a call money rate of 3%, the interest paid will be $150. Keeping all the gains and expenses, the net gain for the investor is $2,050 or 41% of the equity invested.
As the value of the asset changes over time, the percentage of equity in the margin account will also change. The broker expects the investor to maintain a minimum equity percentage, which is called the maintenance margin requirement. In most cases, this requirement is 25% of the position value. However, the brokers may require a higher maintenance margin for highly volatile stocks. If the value of equity falls below the maintenance margin requirement, the buyer will receive a margin call to deposit additional equity.
In our example, the initial stock price was $100 and the initial equity was $50 or 50%. If the stock value falls to $66.67, the equity will drop to $16.67, which is 25% of the stock price. If the stock value falls any further the investor will receive a margin call from the broker. In case the investor fails to deposit additional equity, the broker can closeout the position to avoid further losses.