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MARGIN RULES, REGULATIONS, AND REQUIREMENTS
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The rules, regulations, and requirements regarding margin accounts come from three sources: 1. The Federal Reserve Board sets margin requirements as part of monetary policy. These are referred to as Fed requirements. 2. Stock exchanges also set margin requirements that their member firms are required to observe, and when the exchange setting the requirement is the New York Stock Exchange (NYSE), most or all firms observe the requirement whether or not they are NYSE member firms. These are known as exchange requirements. 3. Brokerage firms set their own, more rigorous margin requirements, and their margin allowances are more restrictive than the Federal Reserve s. They are allowed to do this in order to limit their risk. These rules and regulations are known as house requirements.
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Brokerage firms make money on margin accounts from the interest they charge on the loans and also from commissions on the larger transaction sizes that buying on margin allows. However, lending money carries risks for the brokerage firms similar to the risks that banks face when lending; the borrower may not want to, or may not be able to, pay back the money borrowed.
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REGULATION T
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Current Regulation T requires that investors pay for 50 percent of the value at the time of the transaction. A minimum of $2,000 equity is also required to be in the account. The $2,000 can be in the form of cash or fully paid marginable securities. For example, financing to buy 200 shares of POW Corporation at $106 per share could be as follows:
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Total cost: Investor puts in: Amount borrowed: $21,200 10,600 $10,600 (margin debit)
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If the price of POW Corporation rises to $150 per share, its total market value will be $30,000. The investor owes only the margin debit and whatever interest has accumulated (the debit is a loan, and interest is charged only for the days the debt is outstanding). In the POW Corporation, for example, the investor still owes the debit of $10,600, plus interest:
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Current Market value: Total market value: Debit owed: Investor s equity: $150 per share $30,000 10,600 $19,400
If the investor sells the position and takes profits, the picture would look like this:
Investor s equity: Original investment: Profit: $19,400* 10,600 $ 8,800
*The debit remains constant. It is unaffected by market price changes.
After the margin debit is repaid. Note: There will also be interest charges and commissions for the trades.
PART VI Caution
Essentially, the investor has doubled the gain through leverage by buying twice as many shares, with half of the total amount purchased by means of a loan. Although the maximum of 50 percent loan value is used in this example, it is allowable to borrow less than that amount.
STOCK PRICE DROPS
Using a margin is fine as long as the price of the stock rises. The problems with margins occur when the price begins to drop. What if, instead of rising in price, POW Corporation were to fall to $50 a share
200 POW Corporation $50 per share market value: Margin debit owed: Investor s equity: $10,000 10,600* ($600)
*The debit remains constant. It is unaffected by market price changes.
If the investor sold out at $50 a share, not only would the original investment of $10,600 be lost, but the investor would also owe an additional $600. This is reason enough to watch margined positions carefully.
MAINTENANCE CALL
In reality, the investor would usually receive a margin maintenance call before this low level was ever reached. However, in a rapidly declining market, there might not be enough time to deliver the additional funds or fully paid marginable securities necessary to cover the maintenance call. Maintenance requirements can be anywhere from 25 to 50 percent equity a 30 percent equity requirement is common for many stocks of the current market value or $2,000 (whichever is greater). Although the calculations can become complicated with variations in a margin portfolio, they are based on the following simple formula: Equity = market value debit In other words, an investor can expect a margin maintenance call for the deposit of additional funds or fully paid, marginable securities if the market price of the stock falls below the borrowed amount (debit) plus 25 to 30 percent (the actual amount depends on brokerage firm requirements).
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