Finance

Margin Call

Margin Call

As in Finance we say leverage is a double edge sword so does with the margin as well, Now let us understand about few terms before going into margin calls.

Get complete CFA Online Course by experts Click Here

Brokerage Account:-It is the account that is maintained with the licensed broker which is used for the purchase and sale of investments by the broker on behalf of the customer. However, risks, rewards, Tax obligations lie with the investor himself.

Margin Account:-It is a type of brokerage account where the investor has his own funds(Equity) along with the funds lent by the broker. These funds will be invested in stocks and financial instruments. So these stocks and financial instruments are kept as collateral by the broker for lending. Sometimes the broker can even lend securities instead of funds These funds or securities lent are called Margin Funding.

Margin Trading:-Trading done with a margin account is called Margin trading. This enables the investor to have exposure in the market over and above his possible resources.

MARGIN CALL IN MARGIN TRADING:

The investor uses his own funds along with the borrowed funds to buy investments this is called Buying Margin. In this case, when the market value of the investment falls below a certain percentage there can be a counter-party default risk to the broker. To avoid this risk he can call the investor to maintain his position this is called a Margin call. The percentage below which a call is made is called a maintenance margin. Depending upon the volatility of the markets this maintenance margin would be decided.

Example:- A investor buys Rs 2,00,000 share of Reliance Jio Infocomm Ltd with Rs 1,00,000 as his own funds and Rs 1,00,000 as borrowed funds and with a maintenance margin of 25%. In this case, investors equity is 50% we calculate it with the following formula:

margin

We should always make sure that investors’ equity percentage is not below 25% once it goes less than 25% then there will be a call from the broker. Now let’s see how the margin call operates in different situations:

Share price

Investors equity percentage Call requirement

Amount of call

1,60,000 =37.5% No

(As equity percentage is greater than 25%)

Nil
1,40,000 =28.57% No

(As equity percentage is greater than 25%)

Nil
1,20,000 =16.6666% Yes

(As equity percentage is less than 25%)

10,000

(1,20,000  X 8.3333%)

If we want to summarize the entire table we can say that whenever the share price falls below 66.6666% there would be a Margin Call.

Get complete FRM Online Course by experts Click Here

How to calculate this 66.666%?

In investors equity percentage formula if we make the market value of securities as subject the formula changes in the following manner:

margin2

Using the above formula, we get the minimum market value of securities as 1,33,333.333 and if we calculate it as a percentage of 2,00,000(initial purchase price) we get the percentage as 66.666%. We can find margin calls not only in margin trading but also in Derivatives trading.

MARGIN CALL IN FUTURES CONTRACT:

A trader went long(f+) at Rs 500 per share for 1000 shares. Initial margin is 20%(1,00,000) and maintenance margin is 15%(75,000).(We have already discussed regarding maintenance margin. Initial margin is the amount deposited by the investor as security when using a margin account, generally, it is expressed as a percentage of the purchase price. If the margin reduces below the maintenance margin the trader must bring the margin back to initial )

Now let’s see how the margin call works here:

  • On 1st day Share price becomes 540:-there would be a gain of 40,000(40 x 1000 shares) and margin becomes 1,40,000.
  • On the 2nd day Share price becomes 490:- there would be a loss 0f 50,000(50 x 1000 shares) and margin becomes 90,000(1,30,000-50,000) since the margin is more than maintenance margin there won’t be any call
  • On the 3rd-day share price becomes 430:- there would be a loss of 60,000(60 x 1000 shares) and margin becomes 30,000 (90,000-60,000). Here margin is less than maintenance margin, there will be a margin call and the trader has to bring the margin back to initial i.e, 1,00,000
  • On the 4th-day share price becomes 520:- there would be a gain of 90,000(90 x 1000 shares) and the margin becomes 1,90,000(1,00,000 + 90,000)

In the case of future contracts, the margin requirements would be maintained with the Clearinghouse. The above same example can be linked with Forward Contracts as well.

COVERING A MARGIN CALL:

Its very simple to cover a margin call, we can select any of the following methods:

  1. Just pay the additional amount required to cover the margin.
  2. Deposit unmargined securities to meet the maintenance margin requirement.
  3. Selling margined securities to meet the maintenance margin requirements.

Get complete CFA Online Course by experts Click Here

IF MARGIN CALL IS NOT PAID?

If the margin requirement is not fulfilled then the brokerage firm may force sell or liquidate the position(square of the position). This may happen with or without notice. Generally 2-5 days time will be given to fulfill the maintenance margin and of course several notices will also be given. In adverse cases, there can be a legal issue as well. Sometimes the brokerage firm may inform to credit rating agencies due to which there might be a fall in credit rating.

 

Author: Akshay Sandhu

Related:

What is Clearing Margin?

How does SPAN Margin System work?

Related Posts

Leave a Reply

Your email address will not be published. Required fields are marked *

3 × two =