Product-Specific Strategies for Margin Accounts

Instructor: Yusuf Abdullah

Yusuf has taught Science and Mathematics at school level and Finance and Economics at University level. He has recently earned his Ph.D in Financial Econometrics.

The lesson deals with the product-specific requirements and strategies for margin accounts. You'll learn about margin requirements for fixed income securities, equities, and mutual funds.

Margin Investing

Mark has been an investor for a long time now. He has invested in a number of assets and is interested in earning higher returns. He shared his goal with his investment advisor, Mila, who suggests investment through margin. Margin investing involves making investments using debt. As a result of debt, the investment value increases, and so does the magnitude of the risk.

Mark is excited and wants to proceed with this strategy. Mila cautions him and explains that margin investing is risky. She wants him to be informed about techniques related to different asset classes, limits to margin trading, and the amount of debt that he can take.

Requirements and Strategies

Mila states that margin limits, requirements, and strategies depend on each asset class. A simple way to look at it is that margin is like a loan from the lender, and the investor is the borrower. The risk of the loan is dependent on the asset it is invested in. So when the lender is sure of the payments, he would lend more and at a lower rate. When the asset is risky, the lender would lend less and at a higher rate. Let's see now how different assets fare.

Fixed Income

Fixed income is relatively less risky among the asset classes. Treasury securities are fixed income securities issued by the US Treasury and backed by the US government. This makes them such safe investments that return on these securities is used as a proxy for the risk-free rate. Now it doesn't make sense to borrow money and invest in these securities because the borrowing rate would be higher than the return on the treasury securities. Therefore, these securities can be sold short, and the funds can be invested elsewhere.

In general, the risk of fixed income products can be calculated by duration, which is the percentage change in price for a unit percentage change in rates across all maturities. Duration is directly related to time to maturity. Longer maturity bonds are riskier and require a higher margin.

Other bonds, such as municipal bonds and corporate bonds are riskier and can be bought by shorting the treasuries or by taking a loan. The requirements for maintenance margin for municipal bonds is usually 25% to 50% depending on the ratings. The regulatory margin requirements for corporate bonds are:

Bond Type Initial Margin Maintainence Margin
Investment Grade 10% * Market Value 10% * Market Value
Non-Investment Grade Lower of 20% * Market Value OR 7% * Face Value Lower of 20% * Market Value OR 7% * Face Value
Speculative Grade 50% * Market Value 50% * Market Value
Junk Grade 70% * Market Value 70% * Market Value

Equity

Mark asks if the margin for equity is greater than that of the fixed-income securities. Mila explains that since equities are riskier than the fixed-income securities in general, the margin requirement is higher. In general, regulatory requirements for equities require a minimum of 50% as initial margin and 25% as the maintenance margin. This can, however, be higher and increases as the risk in the security increases.

Mutual Funds

Mutual funds are of two types:

  • Closed-ended mutual funds: constant number of shares and cannot issue more shares.
  • Open-ended mutual funds: issue or retire shares as needed.

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