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Online trading and electronic communications networks have already changed the land-
scape of the financial markets, and this trend can only be expected to continue. The nearby
box considers some of the implications of these new technologies for the future structure of fi-
nancial markets.

When purchasing securities, investors have easy access to a source of debt financing called bro-
ker™s call loans. The act of taking advantage of broker™s call loans is called buying on margin.
Purchasing stocks on margin means the investor borrows part of the purchase price of the
stock from a broker. The margin in the account is the portion of the purchase price contributed
by the investor; the remainder is borrowed from the broker. The brokers in turn borrow money
Describes securities
from banks at the call money rate to finance these purchases; they then charge their clients that
purchased with money
rate (defined in Chapter 2), plus a service charge for the loan. All securities purchased on mar-
borrowed in part from
a broker. The margin gin must be maintained with the brokerage firm in street name, for the securities are collateral
is the net worth of the for the loan.
investor™s account.
The Board of Governors of the Federal Reserve System limits the extent to which stock pur-
chases can be financed using margin loans. The current initial margin requirement is 50%, mean-
ing that at least 50% of the purchase price must be paid for in cash, with the rest borrowed.
The percentage margin is defined as the ratio of the net worth, or the “equity value,” of the
account to the market value of the securities. To demonstrate, 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 $4,000 from a broker. The initial balance sheet looks like this:

Assets Liabilities and Owners™ Equity
Value of stock $10,000 Loan from broker $4,000
Equity $6,000
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

3 How Securities Are Traded

The initial percentage margin is

Equity in account $6,000
Margin .60, or 60%
Value of stock $10,000
If the stock™s price declines to $70 per share, the account balance becomes:

Assets Liabilities and Owners™ Equity
Value of stock $7,000 Loan from broker $4,000
Equity $3,000

The assets in the account fall by the full decrease in the stock value, as does the equity. The
percentage margin is now

Equity in account $3,000
Margin .43, or 43%
Value of stock $7,000

If the stock value were to fall below $4,000, owners™ equity would become negative, mean-
ing the value of the stock is no longer sufficient collateral to cover the loan from the broker.
To guard against this possibility, the broker sets a maintenance margin. If the percentage mar-
gin falls below the maintenance level, the broker will issue a margin call, which requires the
investor to add new cash or securities to the margin account. If the investor does not act, the
broker may sell securities from the account to pay off enough of the loan to restore the percent
age margin to an acceptable level.
Margin calls can occur with little warning. For example, on April 14, 2000, when the
Nasdaq index fell by a record 355 points, or 9.7%, the accounts of many investors who had
purchased stock with borrowed funds ran afoul of their maintenance margin requirements.
Some brokerage houses, concerned about the incredible volatility in the market and the possi-
bility that stock prices would fall below the point that remaining shares could cover the
amount of the loan, gave their customers only a few hours or less to meet a margin call rather
than the more typical notice of a few days. If customers could not come up with the cash, or
were not at a phone to receive the notification of the margin call until later in the day, their ac-
counts were sold out. In other cases, brokerage houses sold out accounts without notifying
their customers. The nearby box discussed this episode.
An example will show how maintenance margin works. Suppose the maintenance margin
is 30%. How far could the stock price fall before the investor would get a margin call? An-
swering this question requires some algebra.
Let P be the price of the stock. The value of the investor™s 100 shares is then 100P, and the
equity in the account is 100P $4,000. The percentage margin is (100P $4,000)/100P. The
price at which the percentage margin equals the maintenance margin of .3 is found by solving
the equation

100P 4,000

which implies that P $57.14. If the price of the stock were to fall below $57.14 per share,
the investor would get a margin call.

3. Suppose the maintenance margin is 40%. How far can the stock price fall before Concept
the investor gets a margin call?
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

Margin Investors Learn the Hard Way
That Brokers Can Get Tough on Loans
pleted, an investor™s equity”the current value of the
For many investors, Friday, April 14, was a frightening
stocks less the amount of the loan”must be equal to
day, as the Nasdaq Composite Index plunged a record
at least 25% of the current market value of the shares.
355.49 points, or 9.7%. For Mehrdad Bradaran, who
Many brokerage firms set stricter requirements. If
had been trading on margin”with borrowed funds”it
falling stock prices reduce equity below the minimum,
was a disaster.
an investor may receive a margin call.
The value of the California engineer™s technology-
The actual amount an investor must fork over to
laden portfolio plummeted, forcing him to sell $18,000
meet a margin call can be a multiple of the amount
of stock and to deposit an additional $2,000 in cash
of the call. That is because the value of the loan
in his account to meet a margin call from his broker,
stays constant even when the market value of the se-
TD Waterhouse Group, to reduce his $52,000 in
curities falls.
Many investors were stunned by their firms™ actions,
At least the worst was over, Mr. Bradaran figured, as
either because they didn™t understand the margin rules
tech stocks soared the following Monday”only to learn
or ignored the potential risks. There aren™t any public
Monday evening that Waterhouse™s Santa Monica,
statistics on the number of investors affected, but the
Calif., branch had sold an additional $20,000 of stock
margin calls accompanying April™s market roller coaster
“without even notifying me,” he says. His account, which
have clearly hit a nerve.
had been worth $28,000 not including his borrowed
Some clients of other brokerage firms were affected
funds, is now worth just $8,000, he says. “If they had
as well. Larry Marshall, the owner of an executive-
given me a call, and I had deposited the money, I would
search firm who lives in Malibu, Calif., says Merrill
have gained back at least half” of the $20,000 in losses
Lynch & Co. told him the Monday after the market™s
when the market rebounded, he claims.
drop that he would have to meet an $850,000 margin
Mr. Bradaran is one of many investors who have dis-
call immediately. Normally, he says, the firm gives him
covered that buying stocks with borrowed funds”always
three to five days to come up with additional funds.
a risky strategy”can be riskier than they ever imagined
A Merrill Lynch spokeswoman says “as a matter of
when the market is going wild. That™s because some
good business practice in periods of extreme volatility,
brokerage firms exercised their right to change margin-
offices may be asked to exercise the most prudent
loan practices without notice during the market™s recent
measures”clearly outlined in our margin policy”to re-
nose dive.
sponsibly manage the risk associated with leveraged
The result: Customers were given only a few hours
or less to meet a margin call, rather than the several
Clearly, a lot of investors would have benefited from
days they typically are given to deposit additional cash
additional time because of the market™s sharp rebound.
or stock in their brokerage account, or to decide which
But they, and the brokerage firms on the hook for their
securities they want to sell to cover their debts. And
loans, could have been in even worse shape if stock
some firms, such as Waterhouse, also sold out some
prices had continued to plummet.
customers™ accounts without any prior notice, as they
are allowed to under margin-loan agreements signed
by customers. SOURCE: Abridged from Ruth Smith, “Margin Investors Learn the
Investors generally can borrow as much as 50% of Hard Way That Brokers Can Get Tough on Loans,” The Wall Street
Journal, April 27, 2000.
the value of their stocks. Once the purchase is com-

Why do investors buy securities on margin? They do so when they wish to invest an
amount greater than their own money allows. Thus, they can achieve greater upside potential,
but they also expose themselves to greater downside risk.
To see how, let™s suppose an investor is bullish on IBM stock, which is selling for $100 per
share. An investor with $10,000 to invest expects IBM to go up in price by 30% during the
next year. Ignoring any dividends, the expected rate of return would be 30% if the investor in-
vested $10,000 to buy 100 shares.
But now assume the investor borrows another $10,000 from the broker and invests it in
IBM, too. The total investment in IBM would be $20,000 (for 200 shares). Assuming an in-
terest rate on the margin loan of 9% per year, what will the investor™s rate of return be now
(again ignoring dividends) if IBM stock goes up 30% by year™s end?
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

EXCE L Applications www.mhhe.com/bkm

> Buying on Margin

The Excel spreadsheet model below is built using the text example for IBM. The model makes
it easy to analyze the impacts of different margin levels and the volatility of stock prices. It also
allows you to compare return on investment for a margin trade with a trade using no borrowed
funds. The original price ranges for the text example are highlighted for your reference.
You can learn more about this spreadsheet model using the interactive version available on our
website at www.mhhe.com/bkm.

2 Buying on Margin Ending Return on Ending Return with
3 St Price Investment St Price No Margin
4 Initial Equity Investment 10,000.00 51.00% 30.00%
5 Amount Borrowed 10,000.00 30 -149.00% 30 -70.00%
6 Initial Stock Price 100.00 40 -129.00% 40 -60.00%
7 Shares Purchased 200 50 -109.00% 50 -50.00%
8 Ending Stock Price 130.00 60 -89.00% 60 -40.00%
9 Cash Dividends During Hold Per. 0.00 70 -69.00% 70 -30.00%
10 Initial Margin Percentage 50.00% 80 -49.00% 80 -20.00%
11 Maintenance Margin Percentage 30.00% 90 -29.00% 90 -10.00%
12 100 -9.00% 100 0.00%
13 Rate on Margin Loan 9.00% 110 11.00% 110 10.00%
14 Holding Period in Months 12 120 31.00% 120 20.00%
15 130 51.00% 130 30.00%
16 Return on Investment 140 71.00% 140 40.00%
17 Capital Gain on Stock 6000.00 150 91.00% 150 50.00%
18 Dividends 0.00
19 Interest on Margin Loan 900.00
20 Net Income 5100.00
21 Initial Investment 10000.00
22 Return on Investment 51.00%
24 Margin Call:
25 Margin Based on Ending Price 61.54%
26 Price When Margin Call Occurs $71.43
29 Return on Stock without Margin 30.00%

The 200 shares will be worth $26,000. Paying off $10,900 of principal and interest on the
margin loan leaves $15,100 (i.e., $26,000 $10,900). The rate of return in this case will be

$15,100 $10,000

The investor has parlayed a 30% rise in the stock™s price into a 51% rate of return on the
$10,000 investment.
Doing so, however, magnifies the downside risk. Suppose that, instead of going up by 30%,
the price of IBM stock goes down by 30% to $70 per share. In that case, the 200 shares will
be worth $14,000, and the investor is left with $3,100 after paying off the $10,900 of princi-
pal and interest on the loan. The result is a disastrous return of

3,100 10,000


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