Market Mechanics-Investment Managment And Portfolio-Lecture Notes, Study notes of Investment Management and Portfolio Theory

Download Market Mechanics-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 5 MARKET MECHANICS TYPES OF ACCOUNTS: People who buy or sell stock through a brokerage firm have an individual account in which they make their trades. While a single account number is associated with each investor, these accounts have important subsidiary accounts. Two such accounts are cash account and margin account. 1. Cash Account: Every investor with a brokerage account automatically has a cash account. In a cash account, an investor must come up with cash equal to the full value of the securities purchased, unless sufficient funds are already in the accounts. Dividends and interest accumulate in the cash account as they are earned. The investor did not borrow to buy the stock, so the equity on the balance sheet equals the total assets; there are no liabilities. 2. Margin Account: Margin account are extremely useful, but, like most investment, need respect. A margin account permits on investor to borrow part of the cost of investment firm a brokerage firm. This account allows an investor to round up and buy a round lot, or to add leverage to investments the same way a real state speculator gets leverage by purchasing land with borrowing funds. Buying Power: Buying power is a measure of how much more can be spent for securities without having to put up any additional cash. One of the most common question brokers get from clients is, "What's my buying power?" The software running on a broker's desktop monitor may have a menu item enabling the broker to quickly bring up the buying power figure when a customer asks. Brokers and investors both probably should know how to compute this statistic; fortunately, it is not difficult. Regulation T currently provides an initial margin requirement of 50 percent. Therefore, an investor can borrow money from the broker up to the point at which the debt balance equals the account equity. When these two figures are equal the margin loan amounts to 50 percent of the portfolio total assets. At this point the buying power is zero. Buying power can be calculated by solving this equation; B = [1/m-1] E-D Where B = buying power M = initial margin requirement D = debt E = equity With the current 50 percent initial requirement, the formula for determining buying power is simply the account equity minus the debt balance. With a 50% initial margin, buying power = equity – debt balance. Withdrawing Cash: Buying power can also be used to withdraw cash from the account. Taking cash out reduces the total assets and the account equity; buying power is doubly reduced by a cash docsity.com y g ( ) withdrawal. To determine how much can be withdrawn in cash, subtract the margin balance from the account equity and divide by two. Margin Calls: What happens if the market moves the other way? The maintenance margin enters the picture in this scenario. If equity declines too far, the investor must deposit more assets (usually cash and cash equivalents) into the account, or some security position must be involuntarily closed out to reduce the amount of margin debt. Such a requirement is a margin call. The minimum portfolio value can be determined by dividing the debit balance by the quantity one minus the maintenance margin Minimum portfolio value = debit balance . 1- Maintenance margin Once an investor receives a margin call, most brokerage firms require the investor to deposit sufficient funds to return the portfolio to the full initial margin condition of 50 percent equity. This investor is likely to receive a telephone call indicating that margin call is on the way. A paper notice will arrive in the mail with in a day or so. An investor who is unable to deposit sufficient funds to meet the margin calls must sell stock to get the balance sheet in order. Selling stock produces cash that immediately used to pay down the margin loan. Meeting the margin call this way requires the sale of sufficient shares to meet the dollar amount of the margin call. A margin call is inevitable if the securities in the portfolio do not appreciate or generate income. As time passes, interest accrues on the margin loan, so equity will progressively decreases. Eventually equity will decline to the 30 percent make if the investment is all dogs. Notice also that if securities must be sold because of margin call, the sale occurs when the market is down the worst possible time. Once an investor receives a margin call, funds must usually be added to return to the 50 percent equity percent equity position. Variations on the Margin Account: Some brokerage firms offer products that are similar to a traditional margin account but offer additional flexibility to the customer. PaineWebber, for instance, offers a “Personal Security Loan Account” that allows customers to borrow against the securities in their accounts. This account is set up independently of the regular investment account with the loan proceeds used for education, home improvement, car payments, or other similar uses. Because the loan is not being used to purchase additional securities, the Federal Board considers such a loan to be less risky and therefore permits borrowing a great percentage of the portfolio value. An investor can borrow up to 70 percent of the value of the stocks and corporate bonds (compared to only 50 percent in a regular margin account), and up to 90 percent of the value of government securities. Margin and Speculation: Some market observers view the level of margin debt as a precursor of things to come with the market averages. Margin buying has historically moved in tandem with popular averages like the Dow Jones Industrial Average and the S&P 500. As margin debt has increased, so has the level of stoke prices, and vice-versa. It is always dangerous to assume the past will repeat itself, but you should not ignore past patterns, either. docsity.com