Securities: Margin Trading

Unlocking Opportunities with Broker's Call Loans: Buying Securities on Margin

Understanding Broker's Call Loans and Buying on Margin

When it comes to purchasing securities, investors have a powerful tool at their disposal - broker's call loans. These loans provide easy access to debt financing, enabling investors to buy stocks on margin. Buying on margin is akin to obtaining a helping hand from a broker to acquire stocks by borrowing a portion of the purchase price. Imagine it as getting a boost from a friend to reach for a higher shelf in the supermarket, even when you can't quite reach it on your own.

Contributions and Borrowings: Exploring Margin Accounts

When investors buy stocks on margin, they contribute a portion of the purchase price from their own funds. This contribution is referred to as the margin in the account. However, since the entire purchase price may exceed the investor's available funds, the remaining amount is borrowed from the broker. In essence, the broker acts as a financial bridge, enabling investors to access stocks that would have otherwise been out of reach. Picture it as a bridge connecting two sides of a river, allowing you to explore new opportunities that lie on the other side.

Broker's Call Loans: The Inner Workings

Brokers facilitate these margin purchases by borrowing money from banks at the call money rate. They then extend these funds to their clients, charging the call money rate along with a service charge for the loan. This process is similar to a relay race, where brokers receive the baton from the banks and pass it on to investors, helping them participate in the stock market with additional financial support.

Collateral and Street Name: Securing the Margin Loans

As a safeguard for the loans provided, all securities purchased on margin must be held by the brokerage firm in street name. This means that the securities are registered under the brokerage firm's name, serving as collateral for the loan. Imagine your securities as valuable treasures, securely stored in a bank's vault while you make use of the borrowed funds to explore various investment opportunities.

Margin Requirements: Navigating the Federal Reserve's Guidelines

The Board of Governors of the Federal Reserve System imposes limitations on the extent of stock purchases financed through margin loans. Currently, the initial margin requirement is set at 50%. This implies that investors must contribute at least 50% of the purchase price in cash, while the remaining portion can be borrowed. Let's consider an example:

Suppose an investor wishes to buy $10,000 worth of a stock. With a 50% initial margin requirement, the investor needs to contribute $5,000 in cash while borrowing the remaining $5,000 from the broker.

Maintenance Margin and Margin Calls: A Safety Mechanism

To protect against potential negative equity situations, where the value of the stock is no longer sufficient to cover the loan, brokers set a maintenance margin. If the margin percentage falls below this level, the broker issues a margin call. This call requires the investor to add new cash or securities to the margin account. Failure to take action may lead to the broker selling securities from the account to repay a portion of the loan, restoring the margin percentage to an acceptable level. Let's illustrate this with a scenario:

Suppose an investor buys $10,000 worth of stock with $5,000 in cash and $5,000 borrowed. The maintenance margin is set at 30%. If the value of the stock falls to $7,000, the equity in the account would be $2,000 (initial investment of $5,000 - stock value of $7,000). The margin percentage would be 28.57% (equity of $2,000 divided by the stock value of $7,000 multiplied by 100). Since the margin falls below the maintenance level of 30%, the broker issues a margin call, requiring the investor to add additional cash or securities to restore the margin to an acceptable level.

The Upside Potential and Downside Risk

Investors opt to buy securities on margin when they seek to invest more than their available funds allow. This approach offers the potential for greater returns, much like spreading your wings and soaring higher towards the sky. However, it's crucial to bear in mind that buying on margin also exposes investors to greater downside risk. It's akin to climbing a tall mountain; while the view from the top is breathtaking, the potential fall can be equally steep.

This article takes inspiration from a lesson found in FIN 4504 at the University of Florida.