XIV. MARGIN INVESTING

A. DEFINITIONS 1.Leverage – Using borrowed money to multiply investment returns 2.Margin Loan – A loan from a brokerage firm secured by stock in a brokerage account 3.Margin Account – A type of brokerage account that allows loans against the securities in the account 4.Initial Margin – The dollar value of cash and/or securities that is required to be held in a brokerage account to purchase additional securities – the minimum initial margin set by SEC regulations is 50% of the value of securities to be purchased on margin

A. DEFINITIONS 5.Maintenance Margin – The dollar value of cash and/or securities that is required to be held in a brokerage account as security for a margin loan – the minimum maintenance margin set by SEC regulations is 25% of the value of the securities that were purchased on margin, most brokerage firms require a 30% maintenance margin 6.Margin Percentage – Calculated as Owner’s Equity/Total Account Assets (Equity as a percentage of assets) 7.Margin Call – When the value of the securities in an account with a margin loan declines below the maintenance margin – when a margin call occurs, the investor is required to add additional cash or securities to the margin account

B. EXAMPLE 1 You have $1,000 available to invest. You believe that a stock that is trading at $10.00 per share will increase in value. After 1 year, the stock price increases to $11.00 per share and you sell 1.Purchase Stock Long – 100 shares at $10.00 per share costs $1,000. a.Capital gain = $1.00/share x 100 shares = $100 b.Rate of return = $100 (capital gain)/$1,000 (original investment) = 10% 2.Purchase Stock on Margin – With a 50% initial margin, you can purchase 200 shares ($1,000 cash, $1,000 loan) a.Total proceeds from the stock sale = $2,200 b.You repay the loan ($1,000) c.Capital gain = $1.00/share x 200 shares = $200 [or, $2,200 proceeds - $1,000 loan - $1,000 initial investment] d.Rate of return = $200 (capital gain)/$1,000 (original investment) = 20% e.BUT, the rate of interest on the borrowed funds (margin interest rate) can have a significant impact on the actual (net) rate of return

B. EXAMPLE 1(A) – Including Margin Loan Interest in the Calculation 1.Purchase Stock on Margin With a 10% Annual Interest Rate – With a 50% initial margin, you can purchase 200 shares ($1,000 cash, $1,000 loan) a.Total proceeds from the stock sale = $2,200 b.You repay the loan ($1,000) c.You pay interest on the loan ($1,000 x 10% per year over one year = $100) d.Capital gain = $1.00/share x 200 shares = $200 - $100 (interest on margin loan) = $100 [or, $2,200 proceeds - $1,000 loan - $100 interest on margin loan - $1,000 initial investment] e.Rate of return = $100 (capital gain)/$1,000 (original investment) = 10%

C. EXAMPLE 2 You have $1,000 available to invest. You believe that a stock that is trading at $10.00 per share will increase in value. After 1 year, the stock price increases to $12.00 per share and you sell 1.Purchase Stock Long – 100 shares at $10.00 per share costs $1,000. a.Capital gain = $2.00/share x 100 shares = $200 b.Rate of return = $200 (capital gain)/$1,000 (original investment) = 20% 2.Purchase Stock on Margin With a 10% Annual Interest Rate – With a 50% initial margin, you can purchase 200 shares ($1,000 cash, $1,000 loan) a.Total proceeds from the stock sale = $2,400 b.You repay the loan ($1,000) c.You pay interest on the loan ($1,000 x 10% per year over one year = $100) d.Capital gain = $2.00/share x 200 shares = $400 - $100 (interest on margin loan) = $300 [or, $2,400 proceeds - $1,000 loan - $100 interest on margin loan - $1,000 initial investment] e.Rate of return = $300 (capital gain)/$1,000 (original investment) = 30%

D. EXAMPLE 3 You have $1,000 available to invest. You believe that a stock that is trading at $10.00 per share will increase in value. After 1 year, the stock price decreases to $9.00 per share and you sell 1.Purchase Stock Long – 100 shares at $10.00 per share costs $1,000. a.Capital loss = $1.00/share x 100 shares = -($100) b.Rate of return = -($100) (capital loss)/$1,000 (original investment) = -(10%) 2.Purchase Stock on Margin With a 10% Annual Interest Rate – With a 50% initial margin, you can purchase 200 shares ($1,000 cash, $1,000 loan) a.Total proceeds from the stock sale = $1,800 b.You repay the loan ($1,000) c.You pay interest on the loan ($1,000 x 10% per year over one year = $100) d.Capital loss = -($1.00)/share x 200 shares = -($200) - $100 (interest on margin loan) = -($300) [or, $1,800 proceeds - $1,000 loan - $100 interest on margin loan - $1,000 initial investment] e.Rate of return = -($300) (capital loss)/$1,000 (original investment) = -(30%)

E. EXAMPLE 4 – MARGIN CALL Assets Liabilities and Account Holder’s Equity Value of Shares = $2, Total Assets = $2,000 Assumes: 1.Buy 200 shares of $10/share 2.Initial Margin = 50% 3.Maintenance Margin = 30% Amount of Margin Loan = $1,000 Account (Owner’s) Equity = $1, Total Liabilities & Owner’s Equity = $2,000 Initial Investment

E. EXAMPLE 4 – MARGIN CALL Assets Liabilities and Account Holder’s Equity Value of Shares = $1, Total Assets = $1,400 Assumes: 1.Buy 200 shares of $10/share 2.Initial Margin = 50% 3.Maintenance Margin = 30% Amount of Margin Loan = $1,000 Account (Owner’s) Equity = $ Total Liabilities & Owner’s Equity = $1,400 Stock Declines to $7.00 share, Margin Call ! Owner’s Equity = $400; Margin Percentage = $400 (Owner’s Equity)/$1,400 (Total Assets) = 28.57%; Must add more cash or securities or pay down the loan Stock Price Falls to $7.00/Share