Buy on Margin and Short-Sell

Buying on Margin

Initial margin (IM) = 60%

100 sh @ $50 = $5,000 ( 0.6 = $3,000 down ($2,000 loan)

B/S

Asset $5,000 Loan $2,000

(P ( SH) Equity $3,000 (A – L)

If price falls to $40:

( B/S

Asset $4,000 Loan $2,000

Equity $2,000

Actual % margin (AM) = Equity/Asset =

2,000/4000 = 50%.

The broker sets a MM (maintenance margin)

If AM < MM, the broker will issue a ‘margin call’ ( Daily ‘marking to market’ : Investor should add new cash or security to the margin account.

• Undermargined: AM < MM

• Overmargined: AM > IM (unrestricted) (> MM)

• Restricted: MM < AM < IM

Undermargined ( Margin call

MM (maintenance margin) = 30% (minimum margin)

Suppose price falls to $25 (from $50):

AM = (2,500 – 2,000) / 2,500 = 500 / 2,500

= 20% < 30% = MM

How far could stock price fall before the investor get a margin call?

AM = Equity / Asset = (P ( SH – Loan)/(P ( SH) ( MM

Example: P = ?, SH = 100; Loan = $2,000; MM = 0.30

(100 ( P - 2,000)/ (100 ( P) = 0.30

P = 2,000/70 = $28.57.

Overmargined:

Suppose price goes up to $60 (from $50)

AM = 4,000 / 6,000 = 67% > IM (= 60%)

B/S

Asset $6,000 Loan $2,000

Equity $4,000

( You can withdraw cash from your account until

AM = 60%.

Example: AM = (6,000 – 2,000 – X) / 6,000 = 0.60 = IM

X = $400 (can borrow $400 from the account)

B/S

Asset $6,000 Loan $2,400

Equity $3,600

Why buy stocks (or bonds) on margin?

To achieve greater upside potential; but expose to great downside risk

Example:

Start with $5,000; P0 = $50; Expect P1 = $65

Borrow $5,000 and Buy SH = 200;

An interest rate on...