Unit 4: Derivatives Part 1

Leveraged positions
Positions an Investor can take
• A position in an asset is the quantity of the instrument that an entity owns or owes
• A portfolio consists of a set of positions
• Long position: own assets or contracts – benefit from an appreciation in the prices of
the assets or contracts owned
• Short position: sell assets that you do not own, or write and sell contracts – benefit
from a decrease in the prices of the assets or contracts sold. Short sellers profit by
selling at high prices and repurchasing at lower prices

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Positions an Investor can take
NB Principles that will be
used with futures trading!
• Leveraged Positions - Margin Accounts
• Since buyers and sellers do not interact directly, there is an incentive for either party
to default if prices move adversely.
• To inhibit default, futures exchanges use margin accounts.
This is effectively the posting of collateral against default.
• The level at which margins are set is crucial for liquidity. Too high levels eliminate
default, but inhibit market participation. Too low levels increase default risk.
• A margin is cash or marketable securities deposited by an investor with his or her
broker
• The balance in the margin account is adjusted to reflect daily settlement
• Margins minimize the possibility of a loss through a default on a contract

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Positions an Investor can take

• Leveraged Positions:
• Traders buy securities by borrowing some of the purchase price
• Usually borrow the money from their brokers (Borrowing part of the total purchase price of
a position using a loan from a broker)
• Borrowed money is called the margin loan, and it is said that you buy on margin
• Interest rate that the buyers pay for the margin loan is called the call money rate
• Trader’s equity is the portion of the security price that the buyer must supply (Investor
contributes the remaining portion)
• Traders who buy securities on margin are subject to minimum margin requirements
• Margin refers to the percentage or amount contributed by the investor

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Positions an Investor can take
• Leveraged Positions:
• Initial margin requirements: minimum fraction of the purchase price that must be trader’s
equity
• Many markets allow brokers to lend their clients more money if the brokers use risk models to
measure and control the overall risk of their clients’ portfolios – called portfolio margining
• Buying securities on margin can greatly increase the potential gains or losses for a given
amount of equity in a position because the trader can buy more securities on margin than he
could otherwise

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Positions an Investor can take
• Leveraged Positions:
• The buyer thus earns greater profits when prices rise and suffers greater losses when prices
fall
• The relation between risk and borrowing is call financial leverage
• Traders leverage their positions when they borrow to buy more securities
• Leverage ratio is the ratio of the value of the position to the value of the equity investment in it
• Leverage ratio indicates how many times larger a position is that the equity that supports it

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Positions an Investor can take

• Leveraged Positions:
• Maximum leverage ratio associated with a position financed by the minimum margin
requirement
1
=
𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡

E.g. If the requirement is 40%, then the maximum leverage ratio is

1
= = 2.5
0.4
The leverage ratio indicates how much more risky a leveraged position is relative to an
unleveraged position

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Positions an Investor can take

• Leveraged Positions:
• Borrowed money is called the margin loan, and it is said that you buy on margin
• Interest rate that the buyers pay for the margin loan is called the call money rate
• Trader’s equity is the portion of the security price that the buyer must supply
• Traders who buy securities on margin are subject to minimum margin requirements
• Initial margin requirements: minimum fraction of the purchase price that must be trader’s
equity

• Total Return depends on the price change of the purchased security, the dividends or interest
paid by the security, the interest paid on the margin loan, and the commissions paid to buy and
sell the security
• Example

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Positions an Investor can take - Example
Computing Total Return to a Leveraged Stock Purchase

A buyer buys stock on margin and holds the position for exactly one year, during which time the stock
pays a dividend. For simplicity, assume that the interest on the loan and the dividend are both paid at
the end of the year.

Purchase price R20/share Call money rate 5%

Sale price R15/share Dividend R0.10/share

Shares purchased 1,000 Commission R0.01/share

Leverage ratio 2.5

1. What is the total return on this investment?

2. Why is the loss greater than the 25% decrease in the market price?

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Positions an Investor can take – Example Solution
Solution to 1:
To find the return on this investment:

1. Determine the initial equity:

The total purchase price is r20,000.

The leverage ratio of 2.5 indicates that the buyer’s equity financed 40 percent = (1 ÷ 2.5) of
the purchase price.

Thus, the equity investment is 40% x R20,000 = R8000

The R12,000 remainder is borrowed.

The actual investment is slightly higher because the buyer must pay a commission of to buy the
stock: R0.01/share R0.01/ 1,000 = R10

• The total initial investment is R8,010.

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Positions an Investor can take – Example Solution

Solution to 1:

2. Determine the equity remaining after the sale:

At the end of the year, the stock price has declined by $5/share.

As a result of the price change the buyer lost:

= R5/share X 1,000 shares = R5000.

In addition, the buyer has to pay interest at 5% on the R12,000 loan

= R600. (5% x 12 000)
The buyer also receives a dividend of R0.10/share, or R100. (0.10/1000)

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Positions an Investor can take – Example Solution
• The trader’s equity remaining after the sale is computed from the initial equity investment as follows
OR
Initial investment R8,010 Proceeds on sale R15,000
Purchase commission -10 Payoff loan -12,000
Trading gains/losses -5,000 Margin interest paid -600
Margin interest paid -600 Dividends received 100
Dividends received 100 Sales commission paid -10
Sales commission paid -10 Remaining equity R2,490
Remaining equity R2,490

Therefore, return on the initial investment of R8,010

Can use either way – both
(2,490−8,010) will lead to the same answer
•= = -68.9%.
8,010

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Positions an Investor can take – Example Solution
Solution to 2:

The realised loss of -68.9% is substantially greater than the stock price return:
R15 - R20)/R20 = -25%.
25% < -68.9%

Most of the difference is because of the leverage with the remainder primarily the result of the
interest paid on the loan.

Based on the leverage alone and ignoring the other cash flows, we would expect that the return on
the equity would be: 2.5 (leverage) x -25% (stock price return)= -62.5%

• In the above example, if the stock dropped more than the buyer’s original 40 percent margin
(ignoring commissions, interest, and dividends), the trader’s equity would have become negative.
• In that case, the investor would owe his broker more than the stock is worth. Brokers often lose
money in such situations if the buyer does not repay the loan out of other funds.

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Positions an Investor can take
• Leveraged Positions:
• To prevent losses as shown in the example, brokers require that margin buyers always
have a minimum amount of equity in their positions – called maintenance margin
requirement
• The maintenance margin requirement is usually 25% of the current value of the
position, but it may be higher or lower depending on the volatility of the instrument and
the policies of the broker
• If the value of the equity falls below the maintenance margin requirement, the buyer will
receive a margin call, or request for additional equity
• If the buyer does not deposit additional equity with the broker in a timely manner, the
broker will close the position to prevent further losses and thereby secure repayment of
the margin loan
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Positions an Investor can take

• Leveraged Positions:
• When buying securities on margin, it is important that you know the price at which you will receive
a margin call if the price drops. This depends on your initial equity amount and on the margin
requirements

Example – Margin Call Price

• A trader buys stock on margin posting 40% of the initial stock price of $20 as equity. The
maintenance margin requirement for the position is 25%. Below what price will a margin call
occur?

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Positions an Investor can take

Example Solution - Margin Call Price

The trader’s initial equity is 40 percent of the initial stock price of $20, or $8 per share.
Subsequent changes in equity per share are equal to the share price change so that equity per share
is equal to $8 + (P - 20) where P is the current share price. The margin call takes place when equity
drops below the 25% maintenance margin requirement. The price below which a margin call will
take place is the solution to the following equation:

𝐸𝑞𝑢𝑖𝑡𝑦/𝑠ℎ𝑎𝑟𝑒 $8 + 𝑃 − 20
= = 25%
𝑃𝑟𝑖𝑐𝑒/𝑠ℎ𝑎𝑟𝑒 𝑃

which occurs at P = 16. When the price drops below $16, the equity will be under $4/share, which is
less than 25% of the price.

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Positions an Investor can take

• Leveraged Positions:
• Traders who sell securities short are also subject to margin requirements because they have
borrowed securities
• Initially, the trader’s equity supporting the short position must be at least equal to the margin
requirement times the initial value of the short position
• If the prices rise, equity will be lost.

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Margin Trading
Margin Trading: Initial Conditions Example

Share Price $100

Initial Margin 60%
Maintenance Margin 40%
Shares Purchased 100

Initial Position The initial margin that needed to be

Stock = $10,000 [100 shares x $100 per share] put down is 60% of the total value
So the borrowed amount is (1-
Borrowed = $4,000 [stock costs $10 000 x (1 – 0.60)] 60%)

Equity = $6,000 [the amount that needs to be put down by the investors]

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Maintenance Margin Example

What happens if the Stock price falls to $70 per share

New Position
Stock = $7,000 [$70 x 100 shares]
Borrowed = $4,000 [does not change]
Equity = $3,000 [the amount left over if we had to pay back our ‘loan’ of $4000]

The Margin % is then calculated as

= $3,000/$7,000 = 43%

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 Margin Call Example

How far can the stock price fall before a margin call?
Let the maintenance margin = 30%

Equity = 100P - $4000

Percentage margin = (100P - $4,000) / 100P

(100P - $4,000) / 100P = 0.30

Solve to find:
P = $57.14

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Table: Illustration of Buying Stock on Margin

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Short Sales

• Purpose: to profit from a decline in the price of a stock or security

• Mechanics
• Borrow stock through a dealer
• Sell it and deposit proceeds and margin in an account
• Closing out the position: buy the stock and return to the party from which it was
borrowed

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Short Sale: Initial Conditions Example
Dot Bomb 1000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price

Sale Proceeds $100,000

Margin & Equities $50,000
Stock Owed 1000 shares

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Example - Dot Bomb falls to $70 per share

Assets Liabilities
$100,000 (sale proceeds) $70,000 (buy shares)
$50,000 (initial margin)
Equity
$80,000

Profit = ending equity – beginning equity

= $80,000 - $50,000 = $30,000
= decline in share price x number of shares sold short

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Short Sale - Margin Call

How much can the stock price rise before a margin call?

($150,000* - 1000P) / (1000P) = 30%

P = $115.38

* Initial margin plus sale proceeds

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Reference list

• Bodie, Z, Kane, A, Marcus, AJ, 1999. Investments. Boston: McGraw-Hill/Irwin.

• Falkena, HB, et al., 1989. The futures market. Halfway House: Southern Book Publishers (Pty) Limited.
• Falkena, HB, et al., 1991. The options market. Halfway House: Southern Book Publishers (Pty) Limited.
• Faure, AP, 2005. The financial system. Cape Town: QUOIN Institute (Pty) Limited.
• Hull, JC, 2000. Options, futures, & other derivatives (4e). London Prentice-Hall International, Inc.
• SAFEX (Financial Derivatives and Agricultural Products Divisions of the JSE Securities Exchange South Africa), 2003. [Online]. Available: www.safex.co.za. [Accessed
October].
• Saunders, A, 2001. Financial markets and institutions (international edition) New York:
• McGraw-Hill Higher Education. Santomero, AM and Babbel, DF, 2001. Financial markets, instruments and institutions (2e). Boston:.McGraw-Hill/Irwin.
• Spangenberg, P, 2000. Forward rate agreements. The Southern African Treasurer. 14. September. 186
• Spangenberg, P, 1999. The mechanics of option-styled interest rate derivatives – caps and floors. The Southern African Treasurer. 11. December.
• Standard Bank., 2004. [Online]. Available: www.warrants.co.za. [Accessed June].
• Steiner, R, 1998. Mastering financial calculations. London: Financial Times Management.
• Investopedia
• The Economicst.com
• Wkipedia

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