Securities Markets - Buying on Margin and Maintenance Margin

The Process of Buying Stock on Margin
Buying a stock on margin is essentially using credit to purchase stock shares, much like using a credit card. A brokerage firm lends money to an investor to buy stocks. The brokerage firm will charge interest on the money it lends. The Federal Reserve Board has placed limits on margin buying. Currently the initial margin requirement (the required equity position to enter into a margin transaction) is 50%, meaning the investor must provide at least 50% of the amount of funds needed to enter into the trade. The brokerage firm will provide the remainder of the funds. The brokerage firm will then hold the securities that are bought as collateral.

If the stock goes up after it is purchased, the investor's profit will be magnified given the stocks purchased on margin. However, if the stock goes down, the losses are then magnified.

Example: Determine the return on a margin trade
Assume that an investor purchased 500 shares of Newco's stock. The shares were trading at $50 when the transaction was executed. Assume the investor was able to sell the shares for $100. To determine the effect of the leverage with purchasing the shares on margin, compute the return on the transaction if (1) no margin was used and (2) 70% initial margin requirement was used. Assume no transaction costs.

Answer:

1) No margin was used
If no margin was used, the initial cash outlay for the shares was $25,000 (500 shares at $50). The investor then sold the shares for $50,000 (500 shares at $100).

The return on the trade was thus ($50,000/$25,000) - 1 = 100%.

2) 70% initial margin requirement
Given the initial margin requirement of 70%, the investor would need an initial cash outlay of $17,500 ($25,000 x 70%). The investor borrowed $7,500 ($25,000 x 25%) from the brokerage firm to complete the transaction.

The investor was then able to sell the shares for $50,000 (500 shares at $100). The investor then repays the amount borrowed of $7,500 and the remaining position would be equal to $42,500 ($50,000 - $7,500).

The return on the trade was thus ($42,500/$17,500) - 1 = 142.9%.

As shown in the examples above, the investor was able to magnify his returns by buying stock on margin.

What is Maintenance Margin?
A maintenance margin is the required amount of securities an investor must hold in his account if he either purchases shares on margin, or if he sells shares short. If an investor's margin balance falls below the set maintenance margin, the investor would then need to contribute additional funds to the account or liquidate stocks in the account to bring the account back to the initial margin requirement. This request is known as a margin call.

As discussed previously, the Federal Reserve Board sets the initial margin requirement (currently at 50%). The Federal Reserve Board also sets the maintenance margin. The maintenance margin, the amount of equity an investor needs to hold in his account if he buys stock on margin or sells shares short, is 25%. Keep in mind, however, that this 25% level is the minimum level set, brokerage firms can increase, but not decrease this level as they desire.

Example: Determining when a margin call would occur.
Assume that an investor had purchased 500 shares of Newco's stock. The shares were trading at $50 when the transaction was executed. The initial margin requirement on the account was 70% and the maintenance margin is 30%. Assume no transaction costs. Determine the price at which the investor will receive a margin call.

Answer:
Calculate the price as follows:

$50 (1- 0.70) = $21.43
  1 - 0.30

A margin call would be received when the price of Newco's stock fell below $21.43 per share. At that time, the investor would either need to deposit additional funds or liquidate shares to satisfy the initial margin requirement.

Effects of the Institutionalization of capital markets
Related Articles
  1. Career Education & Resources

    How Hard are the CFA Exams?

    Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
  2. Professionals

    What it Takes to be a Financial Analyst

    A financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
  3. Career Education & Resources

    Financial Analyst: Career Path & Qualifications

    Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
  4. Career Education & Resources

    Financial Planner: Career Path & Qualifications

    Learn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
  5. Career Education & Resources

    Where to Find Non-Profit Finance Jobs

    The non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
  6. Career Education & Resources

    Portfolio Manager: Career Path & Qualifications

    Learn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
  7. Your Practice

    4 Professional Associations Advisors Should Join

    These four professional organizations are among the most respected and well known in the industry.
  8. Professionals

    Equity Research: Career Path and Qualifications

    Find out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
  9. Professionals

    What's on the CFA Level II Exam?

    The Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
  10. Professionals

    Financial Data Analyst: Career Path & Qualifications

    Learn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Security Analyst

    A financial professional who studies various industries and companies, ...
  4. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center