Buying On Margin

When purchasing securities, investors have easy access to a source of debt financing called brokers' call loans. The act of taking advantage of brokers' call loans is called buying on margin.

Purchasing stocks on margin means the investor borrows part of the purchase price of the stock from a broker. The broker, in turn, borrows money from banks at the call money rate to finance these purchases, and charges its clients that rate plus a service charge for the loan. All securities purchased on margin must be left with the brokerage firm in street name, because the securities are used as collateral for the loan.

The Board of Governors of the Federal Reserve System sets limits on the extent to which stock purchases may be financed via margin loans. Currently, the initial margin requirement is 50%, meaning that at least 50% of the purchase price must be paid for in cash, with the rest borrowed.

The percentage margin is defined as the ratio of the net worth, or "equity value," of the account to the market value of the securities. To demonstrate, suppose that the investor initially pays $6,000 toward the purchase of $10,000 worth of stock (100 shares at $100 per share), borrowing the remaining $4,000 from the broker. The account will have a balance sheet as follows:

Assets

Liabilities and Owner's Equity

Value of stock

$10,000

Loan from broker $4,000 Equity $6,000

The initial percentage margin is

Equity in account $6,000

s Value of stock $10,000

If the stock's price declines to $70 per share, the account balance becomes:

Assets

Liabilities and Owner's Equity

Value of stock

$7,000

Loan from broker $4,000 Equity $3,000

The equity in the account falls by the full decrease in the stock value, and the percentage margin is now

Equity in account $3,000

s Value of stock $7,000

If the stock value were to fall below $4,000, equity would become negative, meaning that the value of the stock is no longer sufficient collateral to cover the loan from the broker. To guard against this possibility, the broker sets a maintenance margin. If the percentage margin falls below the maintenance level, the broker will issue a margin call requiring the investor to add new cash or securities to the margin account. If the investor does not act, the broker may sell the securities from the account to pay off enough of the loan to restore the percentage margin to an acceptable level.

Margin calls can occur with little warning. For example, on April 14, 2000, when the Nasdaq index fell by a record 355 points, or 9.7%, the accounts of many investors who had

CHAPTER 3 How Securities Are Traded purchased stock with borrowed funds ran afoul of their maintenance margin requirements. Some brokerage houses, concerned about the incredible volatility in the market and the possibility that stock prices would fall below the point that remaining shares could cover the amount of the loan, gave their customers only a few hours or less to meet a margin call rather than the more typical notice of a few days. If customers could not come up with the cash, or were not at a phone to receive the notification of the margin call until later in the day, their accounts were sold out. In other cases, brokerage houses sold out accounts without notifying their customers.

An example will show how the maintenance margin works. Suppose the maintenance margin is 30%. How far could the stock price fall before the investor would get a margin call? To answer this question requires some algebra.

Let P be the price of the stock. The value of the investor's 100 shares is then 100P, and the equity in his or her account is 100P - $4,000. The percentage margin is therefore (100P - $4,000)/100P. The price at which the percentage margin equals the maintenance margin of .3 is found by solving for P in the equation

100P

which implies that P = $57.14. If the price of the stock were to fall below $57.14 per share, the investor would get a margin call.

CONCEPT CHECK ^ QUESTION 3

If the maintenance margin in the example we discussed were 40%, how far could the stock price fall before the investor would get a margin call?

Why do investors buy stocks (or bonds) on margin? They do so when they wish to invest an amount greater than their own money alone would allow. Thus they can achieve greater upside potential, but they also expose themselves to greater downside risk.

To see how, let us suppose that an investor is bullish (optimistic) on IBM stock, which is currently selling at $100 per share. The investor has $10,000 to invest and expects IBM stock to increase in price by 30% during the next year. Ignoring any dividends, the expected rate of return would thus be 30% if the investor spent only $10,000 to buy 100 shares.

But now let us assume that the investor also borrows another $10,000 from the broker and invests it in IBM also. The total investment in IBM would thus be $20,000 (for 200 shares). Assuming an interest rate on the margin loan of 9% per year, what will be the investor's rate of return now (again ignoring dividends) if IBM stock does go up 30% by year's end?

The 200 shares will be worth $26,000. Paying off $10,900 of principal and interest on the margin loan leaves $26,000 - $10,900 = $15,100. The rate of return, therefore, will be

$10,000

The investor has parlayed a 30% rise in the stock's price into a 51% rate of return on the $10,000 investment.

Doing so, however, magnifies the downside risk. Suppose that instead of going up by 30% the price of IBM stock goes down by 30% to $70 per share. In that case the 200 shares will be worth $14,000, and the investor is left with $3,100 after paying off the $10,900 of principal and interest on the loan. The result is a disastrous rate of return:

$10,000

Table 3.9 Illustration of Buying Stock on Margin

Change in Stock Price

End of Year Value of Shares

Repayment of Principal and Interest

Investor's Rate of Return*

30% increase

$26,000

$10,900

51%

No change

20,000

10,900

-9%

30% decrease

14,000

10,900

-69%

"Assuming the investor buys $20,000 worth of stock by borrowing $10,000 at an interest rate of 9% per year.

Table 3.9 summarizes the possible results of these hypothetical transactions. Note that if there is no change in IBM's stock price, the investor loses 9%, the cost of the loan.

"Assuming the investor buys $20,000 worth of stock by borrowing $10,000 at an interest rate of 9% per year.

Table 3.9 summarizes the possible results of these hypothetical transactions. Note that if there is no change in IBM's stock price, the investor loses 9%, the cost of the loan.

CONCEPT CHECK ^ QUESTION 4

Suppose that in the previous example the investor borrows only $5,000 at the same interest rate of 9% per year. What will be the rate of return if the price of IBM stock goes up by 30%? If it goes down by 30%? If it remains unchanged?

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