Chapter 13: Problem 470

What is a margin requirement?

Short Answer

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A margin requirement is the minimum amount of money or collateral that a trader or investor must keep in their account to hold a position in a financial instrument. It serves as a safety measure for both investors and brokerage firms, preventing excessive risk-taking by traders. There are two main types of margin requirements: initial margin requirement for opening a new position and maintenance margin requirement for keeping an existing position open. If an account balance falls below the maintenance margin requirement, a margin call may be issued, requiring the investor to deposit additional funds or potentially face forced liquidation of their positions by the brokerage firm.

Step by step solution

Definition of Margin Requirement

A margin requirement is the minimum amount of money or collateral that a trader or investor must keep in their brokerage account to hold a position in a financial instrument. This requirement helps to ensure that there is enough capital in the account to cover potential losses and protect both the investor and the brokerage firm from excessive risk.

Purpose of Margin Requirement

Margin requirements serve as a safety measure for both investors and brokerage firms. They help prevent traders from taking on excessively risky positions by requiring them to have a certain amount of capital in their account to cover potential losses. Margin requirements also protect brokerage firms from the risk of clients not having enough money to cover their positions, which could result in financial losses for the firm.

Types of Margin Requirements

There are two main types of margin requirements that are often discussed: 1. Initial Margin Requirement: This is the minimum amount of money or collateral required to open a new position in a financial instrument. It is usually expressed as a percentage of the total value of the position. 2. Maintenance Margin Requirement: This is the minimum amount of money or collateral that must be maintained in an account to keep an existing position open. If an investor's account balance falls below the maintenance margin requirement, the brokerage firm may issue a margin call, requiring the investor to deposit additional funds or liquidate some of their positions to bring the account balance back up to the minimum level.

Margin Call and Consequences

If an investor's account falls below the maintenance margin requirement, the brokerage firm may issue a margin call. A margin call is a demand for the investor to deposit additional funds or liquidate some of their positions to bring their account balance back up to the minimum level. Failing to meet a margin call can result in the brokerage firm forcibly liquidating some or all of the investor's positions to cover the shortfall, often at a financial loss to the investor.

Example of a Margin Requirement

Suppose an investor wants to purchase 100 shares of a stock that currently trades at \(50 per share. The total cost of the shares would be \)5,000. If the initial margin requirement for this stock is 50%, the investor would need to have at least \(2,500 (50% of \)5,000) in their account to open this position. If the stock's value drops, and the maintenance margin requirement is 25%, the investor must ensure that their account balance remains above \(1,250 (25% of \)5,000) to avoid a margin call. If their account balance falls below the maintenance margin requirement, they must deposit additional funds or risk having their positions forcibly liquidated by the brokerage firm.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Initial Margin Requirement

The initial margin requirement forms the gateway to participating in the world of trading on margin. In essence, this is the entry fee, the minimum percentage of the total trade value that investors must have available in their brokerage account before being able to open a new position in a financial security, like stocks, bonds or futures.

Think of it as a good faith deposit, providing assurance to the brokerage that you have skin in the game. This requirement is set by the brokerage based on regulations and the perceived risk of the instrument being traded. For riskier investments, the initial margin is often higher, reflecting the greater potential for loss.

For example, if an investor wants to purchase securities worth \(10,000 and the initial margin requirement is 50%, the investor must have \)5,000 in their account to place the trade. This ensures that there is cushioning to absorb some losses without immediately endangering the funds borrowed from the broker.

Maintenance Margin Requirement

Once you've entered a position, the maintenance margin requirement takes center stage. It's the minimum balance you must maintain to keep your trades alive. If your account's value dips below this threshold due to market losses, you're in breach of the maintenance margin and at risk of a margin call.

This ongoing requirement ensures that your account has enough equity to secure a buffer against the loan provided by your broker. The maintenance margin is generally lower than the initial margin, allowing some room for the natural ebb and flow of market values.

Let's say the maintenance margin is 30%. Using the previous example of a \(10,000 investment, this means you must maintain an account balance of at least \)3,000. If market fluctuations cause your equity to fall below this level, you'd need to act swiftly to meet the maintenance requirement.

Margin Call

A margin call is the dreaded ring you never want to receive if you're trading on margin. When the equity in your account sinks below the maintenance margin requirement—maybe due to a declining market value of your investments—the broker demands that you deposit more funds or sell some of your assets to restore the balance.

A margin call is not just a polite reminder; it's a broker's enforceable demand to protect their loan to you. If you don't meet the margin call, consequences can be severe—the broker could sell your securities, often at the worst possible time for you financially, to recoup their loan. To avoid this, savvy investors keep a buffer above the maintenance margin or have a plan to quickly add funds if required.

To illustrate, using the previous examples, if the value of the \(10,000 investment falls such that your equity drops below \)3,000, you'll need to add more cash or sell securities. Proactive measures include setting stop-loss orders or closely monitoring positions to prevent portfolios from hitting the dreaded margin call.