Margin Trading

Margin Trading

• SEBI approved margin trading in January 1994• Introduced in February 1994 in India• Taking advantage of broker’s loan is called

buying on margin

Margin

• Portion of the purchase price contributed by the investor

• Reminder is borrowed from broker• Broker borrows from bank • Charges clients the rate + service charge for loan• Who can provide?• Only corporate brokers with a minimum net

worth of Rs. 3 crores

Margin

• In India margin requirements are decided by brokerage house

• Depends upon type of account a customer has

Margin

• Percentage margin:• Ratio of the net worth or equity value of the

account to market value of securities• Example:• Customer initially pays Rs.6k to purchase of

Rs.10k share(100 shares of Rs.100 per share)• Borrowing remaining from Rs.4k from broker

Balance sheet

Assets Liabilities & Owner’s equity

Value of stock Rs.10,000 Loan from broker Rs.4,000

Equity Rs.6,000

Margin

• Initial percentage margin :• Margin= Equity in account

Value of Stock= 6,000 =0.60 10,00060% provided by investor40% provided by broker

Margin• If stock price declines to Rs. 70/share• Account balance comes

• Margin= Equity in accountValue of Stock=3,000 =43% 7,00043% provided by investor57% provided by broker

Assets Liabilities & Owner’s equity

Value of stock Rs.7,000 Loan from broker Rs.4,000

Equity Rs.3,000

Margin• If stock price declines to Rs. 40/share• Account balance comes

• Margin= Equity in accountValue of Stock

= -500 = -0.1433500

Value of stock is no longer sufficient collateral to cover the loan from the broker

Assets Liabilities & Owner’s equity

Value of stock Rs.3500 Loan from broker Rs.4,000

Equity Rs.-500

Maintenance Margin

• To guard against this possibility• Broker sets a maintenance margin• If percentage margin falls from the below the

maintenance level • Margin call• Issue by broker , requiring the investor to add

new cash/securities to the margin account

Margin call

• If investor fails to react• broker may sell the securities from the

account • to pay off enough for the loan to restore

percentage margin to an acceptable level• Can occur within little warning

Suppose the maintenance margin is 30%? How far could stock price fall before the investor would get a margin call?

Margin= Equity in account/ Value of stock =Equity in account=value of stock –loan from broker

=value of stock=No. of share*priceSo, Margin = Value of stock-Loan from broker

Value of stock= No. of share*price- loan from broker

No. of share*price0.30 =100p-4000 =0.30*100p=100p-4000

100p=30p=100p-4000 =4000=100p-30p =4000=70p

=p=4000/70 =p=57.14 Rs.

Suppose the maintenance margin is 30%? How far could stock price fall before the investor would get a margin call?• If stock price comes to Rs. 57.14/share• Account balance comes

• Margin= Equity in accountValue of Stock

= 1714 = 30%5714

Liabilities & Owner’s equity

Value of stock Rs.5714 Loan from broker Rs.4,000

Equity Rs.1714

Suppose the maintenance margin is 40%? How far could stock price fall before the investor would get a margin call?

Margin= Equity in account/ Value of stock =Equity in account=value of stock –loan from broker

=value of stock=No. of share*priceSo, Margin = Value of stock-Loan from broker

Value of stock= No. of share*price- loan from broker

No. of share*price0.40 =100p-4000 =0.40*100p=100p-4000

100p=40p=100p-4000 =4000=100p-40p =4000=60p

=p=4000/60 =p=66.67 Rs.

Suppose the maintenance margin is 40%? How far could stock price fall before the investor would get a margin call?• If stock price comes to Rs. 66.67/share• Account balance comes

• Margin= Equity in accountValue of Stock

= 2667 = 40%6667

Liabilities & Owner’s equity

Value of stock Rs.6667 Loan from broker Rs.4,000

Equity Rs.2667

Suppose the maintenance margin is 40%? How far could stock price fall before the investor would get a margin call?

• If stock price comes to Rs. 60/share• Account balance comes

• Margin= Equity in accountValue of Stock

= 2000 = 33.33%6000

So, when price will be falling down margin comes to 33.33% but investor is supposed to maintain margin of 40%

Liabilities & Owner’s equity

Value of stock Rs.6000 Loan from broker Rs.4,000

Equity Rs.2000

Margin Trading

• Investor: • wish to invest amount greater than their own

money.• Can achieve greater upside potential• Expose themselves to greater downside risk

Margin Trading

• An investor is bullish about A bank stock• Which market price is Rs.100 • Investor has Rs.10k• Expects A bank stock to increase in price by

30% during next week• Ignoring dividend the expected rate of return

would be 30%• If investor spent Rs.10k to buy 100 shares

Margin Trading

• If investor also borrows another Rs. 10k from the broker and invest in A bank

• Total investment in A bank would be Rs.20k (200 shares)

• If the interest rate on loan is 1% per week• What will be the rate of return if A bank stock

price goes up by 30% by week end?

Margin TradingOwn Money Margin Money

10000 10000+10000 Borrowed from broker @1 % interest rate per week

100 price 100 Shares 100 Price 200 Shares

Price remain unchanged Price remain unchanged

10000 Value of stock 20000 Value of stock

-Investment 10000= 0 Profit -Bororwed fund 10000-Interest 100=9900 Net proceedNet profit 9900-10000 investment=-100 Rs

If 10000 profit then 100% 0 profit ? %

If 10000 profit then 100%-100 profit ? %

0*100/10000=0% -100*100/10000=-1%

Margin TradingOwn money Margin Money

Price goes up by 30% Price 130 Price goes up by 30% Price 130

Value of stock 130*100=13000 Value of stock 130*200=26000

-Investment 10000=3000 profit -Borrowed fund 10000-Interest 10026000-10100=15900 ProceedNet profit =Proceed –Investment =15900-10000 =5900

If 10000 profit then 100% 3000 profit then

Sum 1

• Rakesh opens a brokerage account and purchase 300 shares of Reliance Industries at Rs.40 per share. He borrows Rs. 4000 from his broker to help pay for the purchase. The interest rate on the loan is 8 % per year.

• 1.What is the margin in Rakesh’s account when he first purchases the stock?

• 2.If the price falls to Rs.30 per share by the end of the year, what is the remaining margin in his account?

• 3.If the maintenance margin requirement is 30% will he receive a margin call ?

• 4. What is the rate of return on his investment?

Answer

• The stock is purchased for: (300 Rs.40) = Rs.12,000

• The amount borrowed is Rs.4,000. Therefore, the investor put up equity, or margin, of Rs.8,000.

• If the share price falls to Rs.30, then the value of the stock falls to Rs.9,000. By the end of the year, the amount of the loan owed to the broker grows to:

• (Rs.4,000 1.08) = Rs.4,320.• Therefore, the remaining margin in the investor’s

account is: • (Rs.9,000 Rs.4,320) = Rs.4,680.• The percentage margin is now: (Rs.4,680/$9,000) =

0.52 = 52%.• Therefore, the investor will not receive a margin call.

• The rate of return on the investment over the year is:

• (Ending equity in the account Initial equity)/Initial equity

• = (Rs.4,680 Rs.8,000)/Rs.8,000 = 0.415 = 41.5%