Margin Trading Example • Using only a portion of the proceeds for an investment • Borrow remaining component • Margin arrangements differ for stocks and futures

Stock Margin Trading • Greatest margin – Currently 30% – Set by the securities commissions • Minimum margin – Minimum level the equity margin can be (called “maintenance” in USA) • Margin call – Call for more equity funds

Margin Trading - Initial Conditions X Corp 50% 30% 1000 Initial Position $70 Initial Margin Minimum Margin Shares Purchased Stock $70,000 Borrowed $35,000 Equity $35,000

Margin Trading - Minimum Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity $25,000 Margin% = $25,000/$60,000 = 41.67%

Margin Trading - Margin Call • How far can the stock price fall before a margin call?

1 , 000  P  1 , 000 $ 35 , 000  P  30 % Therefore, P = $50 Note: 1,000xP – Amount Borrowed = Equity

Leveraging effect of margin purchases • You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year: – Initial margin: 50% – Financed by a 9% loan for one year – Expected net return: 51% • A 30% drop in the price, though, brings a negative rate of return of -69%.

Short Sales • Purpose: to profit from a decline in the price of a stock or security Mechanics • Borrow stock through a dealer • Sell it and deposit proceeds and margin in an account • Close out the position: buy the stock and return it to the owner

Short Sale - Initial Conditions Z Corp 50% 30% $100 100 Shares Initial Margin Minimum Margin Initial Price Sale Proceeds Margin & Equity Stock Owed $10,000 $ 5,000 $10,000

Short Sale - Minimum Margin Stock Price Rises to $110 Sale Proceeds Initial Margin $10,000 $ 5,000 Stock Owed Net Equity $11,000 $ 4,000 Margin % (4,000/11,000) = 36%

Short Sale - Margin Call • How much can the stock price rise before a margin call?

P

 30% 100

P

So, P = $115.38

Note: $15,000 = Initial margin + sale proceeds