The Investment Process 2-8
money—the margin—and the rest is borrowed. You calculate the margin as a
percentage of the total investment. For example, if you supply $7,000 to
purchase $10,000 in securities, your margin is 70%.
The minimum margin that you must supply when you first purchase the security
is the initial margin. The minimum is set by the Federal Reserve, although
brokerage firms may require more. Since 1974, the minimum has been 50%. So,
for example, if you purchase $50,000 in securities, you must supply $25,000 of
the investment. Note that this is for stocks; there is little initial margin for bonds,
and margin is not allowed for some other types of securities.
Brokerage firms and the exchanges also require maintenance margin, the
minimum amount that must always be present in the account. The NYSE
requires 25% and a typical maintenance margin is 30%. If your margin falls
below 30%, you are subject to a margin call from your broker. This is a demand
by your broker to bring the account back up to the 30% level, pay off part of the
loan, or sell enough securities to maintain the 30%. If you don't comply, your
securities may be sold to repay the loan, with remaining amounts credited to your
Why do investors use margin for financial leverage? When you borrow for an
investment, you magnify your gains or losses. For example, assume you have
$10,000 to invest in a $100 stock. You can purchase 100 shares for cash or 200
shares using a margin loan. Assume the stock price goes to $120. You have now
made 20% on your cash investment, but 40% on your margin investment. But if
the price goes down to $80, you have lost 20% on your cash investment and lost
40% on your margin investment. The joys of leverage!
Lecture Tip: Students seem to grasp the concept of margin very quickly, but get
lost in the details of maintenance margin. The problem seems to relate to the
calculation of percent margin, where the numerator and denominator both
change as the stock price varies. It helps to go through several examples
emphasizing how the margin changes as the stock price changes, and that the
only number that stays constant is the amount borrowed. The investor always
owes this amount to the broker until the loan is repaid.
C. Annualizing Returns on a Margin Purchase
In Chapter 1, we talked about the need to compute percentage returns, but, so
far, we’ve only considered annual returns. Of course, the actual length of time
you own an investment will almost never be exactly a year. To compare
investments, however, we will usually need to express returns on a per-year or
“annualized” basis, so we need to do a little bit more work.
For example, suppose you bought 200 shares of Visa at a price of $80 per share.
In three months, you sell your stock for $85. You didn’t receive any dividends.
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