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Determining Margin Calls

Course: Investment Planning
Lesson 3: Equity Securities

Student Question:

I’m having trouble following the math on the example (shown below) at the bottom of the page. Could you please walk through the calculations? I understand how the initial margin with cash amount is calculated, but it gets a bit fuzzy for me after that.

Example

Jarrod would like to purchase 100 shares of XYZ on margin at $200 per share. He goes to Sorrow Brokerage House and is told that they will require a 60% initial margin call. The settlement date on the transaction is T+2.

Initial Margin

For Jarrod to be able to purchase the 100 shares at $20,000, he will have to put $12,000 of cash into his margin account at Sorrow within 2 days of the transaction.

If Jarrod chooses to collateralize with securities instead of cash, for every thousand dollars worth of securities placed in the account, he could gain credit of $400. Thus, he would need to pledge $50,000 of securities to have sufficient collateral to purchase the $20,000 shares on margin.

Minimum Maintenance Requirement

For Jarrod to remain in good standing, he would need to keep his account at 25% equity after the initial margin. So let’s assume the value of Jarrod’s shares declined to $16,000. That would mean he had lost $4,000. He now has $8,000 in equity, or 50% of the total value, which is well above the minimum maintenance requirement.

Margin Call

For Jarrod to receive a margin call, the total value of equity would need to fall to 25%. That would happen if the total value of the account fell to about $10,650. At that point, if Jarrod had not put any additional cash into the account at any time, he would have $2,650 in equity, which would be 24.9%. At that time, Jarrod would receive a margin call and need to deposit more cash into the account.

Thanks,
Robert

Instructor Response:

Hi Robert-

Happy to help here.

Minimum Maintenance

Here, we are looking to have no less than 25% equity in our position.  Think about it like a home.  If a home is valued at $400,000 and you put $100,000 in cash down, then you have 25% equity.  That remaining $300,000 would be a mortgage.  So, 25% equity and 75% debt (what you owe).  Now if the house increased in value to $500,000, you would still have your $300,000 of debt and your equity position grows to $200,00, or 40%.  However, if the market crashes and your home is now worth $300,000, then you are 100% debt because you have the $300,000 mortgage to pay and only have a home worth that same amount.

Same thing with a brokerage account. In our example, he started with $12,000 in cash and $20,000 worth of stocks. This would mean he has $8,000 he “owes” the brokerage account. So, he has 60% equity and 40% debt.  But he’s fine at this point because if he had to, he could sell all of his stock and get his $12,000 back and pay the brokerage the $8,000 he owes them. Now, if his stocks lose value down to $16,000, he would still have the $8,000 in debt, which means he only has $8,000 in equity.  So, he’s at 50% equity and 50% debt.

Margin Call

A margin call takes place when equity position drops to below 25%.  Or another way to look it, when debt grows to 75%.  So, how do we know when Jarrod hits that? We know he owes $8,000 to the brokerage, so $8,000 is 75% of what?  To calculate that, we do $8,000 divided by .75.  That equals (about) $10,650. If the value of his account drops all the way down to $10,650, that would mean he has $8,000 in debt (75%) and $2,650 in equity (25%).

Does that help to clarify, Robert?  Let me know.

Dan