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.