Equity Investments I
Reading 36. Market Organization and Structure
Learning Outcome Statements
e. compare positions an investor can take in an asset;
f. calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call;
CFA Curriculum, 2020, Volume 5
Why should I choose AnalystNotes?
Simply put: AnalystNotes offers the best value and the best product available to help you pass your exams.
Subject 4. Positions
A short sale allows investors to profit from a decline in a security's price if they believe the security is overpriced. In this procedure an investor (the seller) borrows shares of stock from another investor (the lender) through a broker and sells the shares. The lender keeps the proceeds of the sale as collateral. Later, the investor (the short seller) must repurchase the shares in the market in order to return the shares that were borrowed (covering the short position) to the lender. If the stock price has fallen, the shares will be repurchased at a lower price than that at which they were initially sold, and the short seller reaps a profit equal to the drop in price times the number of shares sold short.
For options, to be long means you are the buyer of the option. To be short means you are the seller of the option. Since the put option contract holder (long) has the right to sell the underlying to the option writer, he or she is actually short the underlying instrument.
The profit in short selling is limited to the value of the security but the loss is theoretically unlimited. In practice, as the price of a security rises, the short seller will receive a margin call from the broker, demanding that the short seller either cover his short position (by purchasing the security) or provide additional cash in order to meet the margin requirement for the security (which effectively places a limit on the amount that can be lost).
Margin transactions occur when investors who purchase stocks borrow part of the purchase price of the stock from their brokers and leave purchased stocks with the brokerage firm because the securities are used as collateral for the loan. The interest rate of the margin credit charged by the broker is typically 1.5% above the rate charged by the bank making the loan. The bank rate (the call money rate) is normally about 1% below the prime rate. The market value of the collateral stock minus the amount borrowed is called the investor's equity.
Investors can achieve greater upside potential, but they also expose themselves to greater downside risk. The leverage equals 1/margin%.
Buying stocks on margin increases the investment's financial risk and thus requires a higher rate of return.
- Percentage margin. The ratio of the net worth or "equity value" of the account to the market value of the securities.
- Maintenance margin. The required proportion of equity to the total value of the stock. It protects the broker if the stock price declines.
- Margin call. If the percentage margin falls below the maintenance margin, the broker issues a margin call requiring the investor to add new cash or securities to the margin account. If the investor fails to provide the required funds in time, the broker will sell the collateral stock to pay off the loan.
Suppose an investor initially pays $6,000 toward the purchase of $10,000 worth of stock ($100 shares at $100 per share), borrowing the remaining from the broker. The maintenance margin is set at 30%. The initial percentage margin is 60%. If the price of the stock falls to $57.14, the value of his stock will be $5,714. Since the loan is $4,000, the percentage margin now is (5,714 - 4,000) / 5714 = 29.9%. The investor will get a margin call.
When investors acquire stock or other investments on margin, they are increasing the financial risk of the investment beyond the risk inherent in the security itself. They should increase their required rate of return accordingly.
Return on margin transaction = (change in investor's equity - interest - commission) / initial investor's equity.
Suppose an investor is bullish (optimistic) on Microsoft stock, which is currently selling at $100 per share. The investor has $10,000 to invest and expects the stock to go up in price by 30% during the next year. Ignoring any dividends and commissions, the expected rate of return would thus be 30% if the investor spent only$10,000 to buy 100 shares.
What will happen if the investor borrows $10,000 from his broker and invests it in the stock (along with his own $10,000)? Assume the interest rate is 9% per year.
- If the stock goes up 30%, his 200 shares will be worth $26,000. Paying off $10,000 of principal and interest on the margin load leaves $15,100. The rate of return, therefore, will be ($15,100 - $10,000) / $10,000 = 51%. Good investment, huh?
- Borrowing to invest, however, magnifies the downside risk. Suppose the stock actually goes down by 30%: his 200 shares of stock are worth $14,000 now. After paying off $10,900 he is left with only $3,100. The result is a disastrous rate of return of -69%!
- If there is no change in the stock price, he will lose 9%, the cost of the loan.
User Contributed Comments 10You need to log in first to add your comment.
Initial Margin is required at the start...
profit% = ((gain or loss on all the shares held)-interest expense))/initial investor's equity
Why is the commission considered part of the initial investment when calculating the profit?
Gee man, I don't know...
easy, transaction costs reduce your profit, which is why discount brokerage firms are so popular these days.
Can someone explain this margin call example.
How do they arrive at the THE LEVERAGE EQUALS TO 1/MARGIN%. Please, can anyone explain?
Besides, if anyone has gone through the schweser then, can anyone explain the below Query in the same topic Los 47f:
Last line of the page
'' 12%*2.5=30% '' , Why multiply by 2.5
12% is the return that is earned just from examining the change in the instrument's value
30% is the return earned by the investor on his initial outlay
Formula to memorise: Loan per share / (1-Maintenance Margin)
Leverage allowed to increase your profit by (1/Margin Required = 1/ 0.5 = 2) if there is no interest charged. Let's take the 1st possibility: bought 100 shares at 100$ and the price increases by 30%. I will make $3,000 on $10,000 initial investment. My return is 30%.
The 2nd possibility: I borrow freely $10,000 from my broker and invest it with my initial $10,000. At the end of the period, the market value of my investment will be $26,000. My totat equity will be $26,000 - $10,000 (borrowed at 0$ cost). My return will be equal to ($16,000 / $10,000) - 1 = 60%.
We can see clearly that I double my return on the 2nd possibility by leveraging. The leverage ratio (1/0.5 = 2) times the return i would have made without leveraging (30%) net of any interest charged is equal to the return with leveraging:
(1/Margin required)*(Initial Return - Interest Chaged on borrowed money) = Return with leverage