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Margin Transactions

27 Sep 2019

Market Organization and Structure (2022 Level I CFA® E…

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Leverage Ratio
The relation between risk and borrowing can be measured by the leverage ratio.
The maximum leverage ratio calculates Znancial leverage if the trader’s equity
position is equal to the initial margin requirement.

Total value of the position

Leverage ratio =
Equity value of the position

1
Maximum leverage ratio =
Initial margin requirement

Return on Margin Transaction

Calculating the rate of return on a margin transaction is the same as calculating
the rate of return on an unlevered transaction; it simply involves one extra step
to calculate and subtract out the margin interest paid. The rate of return should
be calculated based on the initial equity investment, not the total purchase price
of assets. Upfront costs such as commission should be included in the initial
equity amount.

Example of a Margin Transaction

A trader purchases $100,000 worth of a highly volatile stock at a leverage ratio
of 2.5, receives a special dividend of $800 after six months, and sells the stock
exactly one year after purchase at $200,000. The commission is $10 at
purchase. The trader is charged 8% interest on the borrowed money.

To get the rate of return, we just have to Znd the proZt (or loss) and divide it by
the initial equity investment.

Let’s Zrst calculate the amount of money the trader had to borrow in order to
make this transaction.

We can Znd the equity investment by dividing the full $100,000 purchase by the
leverage ratio of 2.5.

$100, 000
Equity investment = = $40, 000
2.5

And the remainder has to be borrowed:

Borrowed amount = $100, 000– $40, 000 = $60, 000

The amount that the trader will have to pay in interest over one year is the
interest rate on the loan multiplied by the loan amount:

Interest paid = $60, 000 × 8% = $4, 800

Moving on to the proZt calculation:

Sale Price $200, 000

Purchase Price −$100, 000
Realized Gain (Loss) $100, 000
Purchase commission −$10
Dividend $800
Margin interest −$4, 800
Sale commission −$10
Return $95, 980

To Znd the total initial equity investment, just take the $40,000 calculated above
and tack on the small commission on purchase of $10:

Equity investment plus commission = $40, 000 + $10 = $40, 010

Finally, we can calculate the rate of return on this trade:

$95, 980
Rate of return = = 239.89%
$40, 010

Margin Call Price

A margin call will take place when equity drops below the maintenance margin
requirement. After the purchase of a security on margin, any changes in that
security’s price will be reeected completely in equity. There is a simple formula
that can be used to Znd the margin call price:

Debt
Margin call price =
1 − Maintenance quad margin

Example of a Margin Call Price

You have been provided the following information:

Purchase price per share: $30

Leverage ratio: 2.0
Maintenance margin: 25%

Remember, the equity investment can be found by dividing the total purchase
price by the leverage ratio:

$30
Equity investment = = $15
2

So, this trade involves $15 of equity and $15 of debt, and we need to Znd at
what price a margin call would take place:

$15 $15
Margin call price = = = $20
1 − 0.25 0.75

Question

What is a trader’s maximum leverage ratio, given an initial margin

requirement of 40%?

A. 1.00
B. 2.50
C. 4.00

Solution

The correct answer is B.

As shown above, the maximum leverage ratio is equal to 1 divided by the

initial margin requirement.
1
Maximum leverage ratio = 0.4
= 2.5

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diana Kriti Dhawan nikhil kumar

2021-07-17 2021-07-16 2021-06-28

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