FINANCIAL SECURITIES: FINANCIAL SECURITIES: MARGIN ACCOUNTSMARGIN ACCOUNTS

CIE 3M1CIE 3M1

AGENDAAGENDA

OPENING A MARGIN ACCOUNTOPENING A MARGIN ACCOUNT MARGIN ACCOUNTS: A DEFINITIONMARGIN ACCOUNTS: A DEFINITION WHAT IS A MARGIN REQUIREMENT?WHAT IS A MARGIN REQUIREMENT? MEETING MARGIN REQUIREMENTSMEETING MARGIN REQUIREMENTS WHAT IS A MARGIN CALL?WHAT IS A MARGIN CALL? CALCULATING MARGINSCALCULATING MARGINS WHY USE MARGINS?WHY USE MARGINS?

OPENING A MARGIN ACCOUNTOPENING A MARGIN ACCOUNT

Accounts at brokerage firms can be either Accounts at brokerage firms can be either CASH accounts or MARGIN accounts.CASH accounts or MARGIN accounts.

Opening a MARGIN account requires some Opening a MARGIN account requires some deposit of CASH or SECURITIES such as T-deposit of CASH or SECURITIES such as T-bills, bonds, other equity securities, etc.bills, bonds, other equity securities, etc.

MARGIN ACCOUNTSMARGIN ACCOUNTS

Used to purchase additional securities by Used to purchase additional securities by leveraging the value of the eligible shares to leveraging the value of the eligible shares to buy more.buy more.

Permits investors to borrow money from a Permits investors to borrow money from a brokerage account for personal purposes at brokerage account for personal purposes at the the margin interest ratemargin interest rate

MARGIN: A DEFINITIONMARGIN: A DEFINITION

Part of the total value of a sale of securities Part of the total value of a sale of securities that a customer must pay to initiate the that a customer must pay to initiate the transaction, with the other part being borrowed transaction, with the other part being borrowed from the brokerfrom the broker

MARGIN REQUIREMENTSMARGIN REQUIREMENTS

The amount of funds the investor must personally The amount of funds the investor must personally provide in a margin account. How much depends on provide in a margin account. How much depends on LOAN VALUELOAN VALUE

CASH has 100% loan value (i.e. $100,000 in cash CASH has 100% loan value (i.e. $100,000 in cash deposits = $100,000 margin)deposits = $100,000 margin)

Other assets such as STOCKS may have 50% or Other assets such as STOCKS may have 50% or lower loan value because of the possible fluctuations lower loan value because of the possible fluctuations (changes) in their market value (i.e. you would have to (changes) in their market value (i.e. you would have to deposit $200,000 worth of common stocks to satisfy a deposit $200,000 worth of common stocks to satisfy a $100,000 margin requirement).$100,000 margin requirement).

MARGIN REQUIREMENTSMARGIN REQUIREMENTS

Margin requirements for stocks traded in Margin requirements for stocks traded in Canada range from 30% to 100% depending Canada range from 30% to 100% depending on the price at which the stock is selling.on the price at which the stock is selling.

Margin requirements INCREASE as the stock Margin requirements INCREASE as the stock prices DECREASES. Why??? Because there prices DECREASES. Why??? Because there is ADDITIONAL RISK associated with LOWER is ADDITIONAL RISK associated with LOWER PRICED STOCKS!!!PRICED STOCKS!!!

MARGIN MARGIN REQUIREMENTS REQUIREMENTS ON LISTED SECURITIES SELLING:ON LISTED SECURITIES SELLING: MAXIMUM LOAN VALUESMAXIMUM LOAN VALUES

Special Securities eligible for reduced Special Securities eligible for reduced marginmargin

70% of market value70% of market value

At $2.00 or overAt $2.00 or over 50% of market value50% of market value

At $1.75 to $1.99At $1.75 to $1.99 40% of market value40% of market value

At $1.50 to $1.74At $1.50 to $1.74 20% of market value20% of market value

Under $1.50Under $1.50 No Loan ValueNo Loan Value

EXAMPLE: MEETING MARGIN EXAMPLE: MEETING MARGIN REQUIREMENTSREQUIREMENTS If the margin requirement is 40% on a If the margin requirement is 40% on a

$100,000 transaction (1000 shares at $100 per $100,000 transaction (1000 shares at $100 per share), the customer must put up $40,000 share), the customer must put up $40,000 borrowing $60,000 from a broker. borrowing $60,000 from a broker.

EXAMPLE: MEETING MARGIN EXAMPLE: MEETING MARGIN REQUIREMENTSREQUIREMENTS The customer could satisfy their margin The customer could satisfy their margin

requirement by putting up $40,000 in cash or requirement by putting up $40,000 in cash or by depositing $80,000 in MARGINABLE by depositing $80,000 in MARGINABLE securities that qualify for a 50% LOAN VALUE. securities that qualify for a 50% LOAN VALUE. – For example, deposition 8,000 stocks of XYZ at a For example, deposition 8,000 stocks of XYZ at a

market value of $10 each = $80,000market value of $10 each = $80,000– $80,000 worth of XYZ times 50% loan value = $80,000 worth of XYZ times 50% loan value =

$40,000$40,000

REMEMBER!REMEMBER!

As stock prices changes, so does investor’s As stock prices changes, so does investor’s equity!equity!

Investor’s Equity = Market value of Investor’s Equity = Market value of COLLATERAL stock minus the amount of COLLATERAL stock minus the amount of money borrowed from the brokermoney borrowed from the broker

Security firms calculate the actual margin in Security firms calculate the actual margin in their customer accounts to see if a “MARGIN their customer accounts to see if a “MARGIN CALL” is required.CALL” is required.

MARGIN (or MAINTENANCE) MARGIN (or MAINTENANCE) CALLSCALLS A demand from the broker for additional cash or A demand from the broker for additional cash or

securities as a result of the actual margin declining securities as a result of the actual margin declining below the margin requirementbelow the margin requirement

Occurs when the market value of the margined Occurs when the market value of the margined securities less the debit balance (amount owed) of the securities less the debit balance (amount owed) of the margin account declines below the required margin. margin account declines below the required margin.

Payable on demand; brokerage house may reserve Payable on demand; brokerage house may reserve the right to take action without notice (i.e. may sell the right to take action without notice (i.e. may sell enough shares from the margin account to satisfy the enough shares from the margin account to satisfy the margin requirement)margin requirement)

MARGIN (or MAINTENANCE) MARGIN (or MAINTENANCE) CALLSCALLS For example, in the previous example the investor deposited For example, in the previous example the investor deposited

8,000 stocks of XYZ that qualifies for a 50% LOAN VALUE at a 8,000 stocks of XYZ that qualifies for a 50% LOAN VALUE at a market value of $10 each (8,000 x $10 = $80,000) to satisfy a market value of $10 each (8,000 x $10 = $80,000) to satisfy a margin requirement of $40,000. margin requirement of $40,000.

If the market value of stock XYZ If the market value of stock XYZ decreasesdecreases to $6 each, then to $6 each, then all of a sudden 8,000 x $6 = $48,000 which would only count all of a sudden 8,000 x $6 = $48,000 which would only count as $24,000 ($48,000 x 50% LOAN VALUE) towards the margin as $24,000 ($48,000 x 50% LOAN VALUE) towards the margin requirement of $40,000. Therefore the investor would no longer requirement of $40,000. Therefore the investor would no longer be covering the margin requirement and the broker would have be covering the margin requirement and the broker would have to make a MARGIN CALL for $16,000 to make up for the to make a MARGIN CALL for $16,000 to make up for the shortfall.shortfall.

MARGIN (or MAINTENANCE) MARGIN (or MAINTENANCE) CALLSCALLS If the market value of stock XYZ If the market value of stock XYZ decreasesdecreases to to

$6 each, then all of a sudden 8,000 x $6 = $6 each, then all of a sudden 8,000 x $6 = $48,000 which would only count as $48,000 which would only count as $24,000$24,000 ($48,000 x 50% LOAN VALUE) towards the ($48,000 x 50% LOAN VALUE) towards the margin requirement of $40,000margin requirement of $40,000. Therefore, . Therefore, the investor would no longer be covering the the investor would no longer be covering the margin requirement and the broker would have margin requirement and the broker would have to make a MARGIN CALL for $16,000 to make to make a MARGIN CALL for $16,000 to make up for the shortfall.up for the shortfall.

MARGIN (or MAINTENANCE) MARGIN (or MAINTENANCE) CALLSCALLS If the investor’s equity EXCEEDS the required If the investor’s equity EXCEEDS the required

margin (i.e. the COLLATERAL stock price margin (i.e. the COLLATERAL stock price increases), the investor can withdraw the increases), the investor can withdraw the EXCESS MARGIN or use it to buy more stockEXCESS MARGIN or use it to buy more stock

MARGIN (or MAINTENANCE) MARGIN (or MAINTENANCE) CALLSCALLS For example, in the previous example the For example, in the previous example the

investor deposited 8,000 stocks of XYZ at a investor deposited 8,000 stocks of XYZ at a market value of $10 each (8,000 x $10 = market value of $10 each (8,000 x $10 = $80,000 that qualify for a 50% LOAN VALUE) $80,000 that qualify for a 50% LOAN VALUE) to satisfy a margin requirement of $40,000. to satisfy a margin requirement of $40,000.

MARGIN (or MAINTENANCE) MARGIN (or MAINTENANCE) CALLSCALLS If the market value of stock XYZ If the market value of stock XYZ increasesincreases to to

$15 each, then all of a sudden 8,000 x $15 = $15 each, then all of a sudden 8,000 x $15 = $120,000 which would count as $120,000 which would count as $60,000$60,000 ($120,000 x 50% LOAN VALUE) towards the ($120,000 x 50% LOAN VALUE) towards the margin requirement of $40,000margin requirement of $40,000. Therefore . Therefore the investor’s equity would EXCEED the the investor’s equity would EXCEED the required margin by $20,000 which he/she can required margin by $20,000 which he/she can withdraw or use to buy more stock.withdraw or use to buy more stock.

CALCULATING MARGINCALCULATING MARGIN

Say that a margin account requires a margin of 40% and the price of Say that a margin account requires a margin of 40% and the price of 1,000 shares of stock XYZ drops from $100 to $90 per share (60% 1,000 shares of stock XYZ drops from $100 to $90 per share (60% borrowed from broker).borrowed from broker).

ACTUAL MARGIN ACTUAL MARGIN = = MARKET VALUE OF SECURITIES – AMOUNT BORROWEDMARKET VALUE OF SECURITIES – AMOUNT BORROWED

MARKET VALUE OF SECURITIESMARKET VALUE OF SECURITIES= = $90,000 - $60,000 $90,000 - $60,000

$90,000$90,000= 33.33%= 33.33%

Obviously 33.33% does not match the 40% original margin Obviously 33.33% does not match the 40% original margin requirement; the investor would receive a MARGIN CALL but for how requirement; the investor would receive a MARGIN CALL but for how much???much???

CALCULATING MARGINCALCULATING MARGIN

The investor should have an The investor should have an equity position of equity position of 40% of $90,000 (= $36,000)40% of $90,000 (= $36,000) and the broker’s and the broker’s maximum loan value is only maximum loan value is only 60% of $90,000 60% of $90,000 (=$54,000).(=$54,000).

Therefore, to restore the appropriate margin, the Therefore, to restore the appropriate margin, the investor could contribute $6,000 which would investor could contribute $6,000 which would reduce the loan from $60,000 to the required reduce the loan from $60,000 to the required $54,000 and increase the equity position from $54,000 and increase the equity position from $30,000 to $36,000.$30,000 to $36,000.

WHY USE MARGINS?WHY USE MARGINS?

Because they magnify any gains on a transaction Because they magnify any gains on a transaction by the RECIPROCAL of the margin requirement by the RECIPROCAL of the margin requirement (1/margin percentage)(1/margin percentage)

BUT margin accounts also magnify any losses on a BUT margin accounts also magnify any losses on a transactiontransaction

AN EXAMPLEAN EXAMPLE

TYPICAL CASE:TYPICAL CASE: Joe buys 1000 shares of XYZ at $10 Joe buys 1000 shares of XYZ at $10 each ($10,000 total). If the stock increases (decreases) to each ($10,000 total). If the stock increases (decreases) to $12 ($8), he stands to gain (lose) $2,000 or 20% on his $12 ($8), he stands to gain (lose) $2,000 or 20% on his initial investmentinitial investment

MARGIN CASE:MARGIN CASE: Jane buys 1000 shares of XYZ at $10 Jane buys 1000 shares of XYZ at $10 each but on MARGIN at the 40% margin rate. Jane’s initial each but on MARGIN at the 40% margin rate. Jane’s initial investment was $4,000 (40% of the $10,000 total cost). If investment was $4,000 (40% of the $10,000 total cost). If the stock increases (decreases) to $12 (to $8), she still the stock increases (decreases) to $12 (to $8), she still stands to gain (lose) $2,000 like Joe BUT Jane’s original stands to gain (lose) $2,000 like Joe BUT Jane’s original cash outlay was only $4,000 so the investor’s gain (loss) is cash outlay was only $4,000 so the investor’s gain (loss) is 2.5 times greater at 40% of the original investment (or 2.5 times greater at 40% of the original investment (or 1/0.4)1/0.4)

REMEMBER!REMEMBER!

REMEMBER, the margin trader must pay the REMEMBER, the margin trader must pay the interest costs on the margin account (i.e. interest costs on the margin account (i.e. the the margin interest ratemargin interest rate = prime lending rate plus a = prime lending rate plus a percentage added by broker)percentage added by broker)

The stock price must rise and cover the cost of the The stock price must rise and cover the cost of the margin interest rate before an investor can make a margin interest rate before an investor can make a profit!profit!