Page 115 - DCOM304_INDIAN_FINANCIAL_SYSTEM

Indian Financial System

Notes business. Arbitraging requires prior application to the governing body "in order to avoid"
the evil of "joint account" with members of other stock exchanges and consequent
involvement of one exchange in the difficulties of another.
7. Security Dealer: This dealer specializes in trading in government securities. He/she mainly
acts as a jobber and takes the risks inherent in ready purchase and sale of securities. The
government securities are over the counter and not on the floor. They maintain daily
contacts with the Reserve Bank of India and common banks and other financial institutions.
As a result of their activities, government securities are quoted finely.

Margin Trading

Margin trading occur when investors who purchase stocks on margin borrow part of the purchase
price of the stock from their brokers, and leave purchased stocks with the brokerage firm in
street name because the securities are used as collateral for the loan. The interest rate of the
margin credit charged by the broker is typically 1.5% above the rate charged by the bank
making the loan. The bank rate (called the call money rate) is normally about 1% below the
prime rate.

1. Percentage margin: The ratio of the net worth, or "equity value" of the account to the
market value of the securities.
2. Maintenance margin: The required proportion of your equity to the total value of the
stock. It protects the broker if the stock price declines.
3. Margin call: If the percentage margin falls below the maintenance margin, the broker
issues a margin call requiring the investor to add new cash or securities to the margin
account. If the investor fails to provide the required funds in time, the broker will sell the
collateral stock to pay off the loan.

Example: Suppose an investor initially pays ` 6,000 towards the purchase of ` 10,000
worth of stock (` 100 shares at ` 100 per share), borrowing the remaining from the broker. The
maintenance margin is set to be 30%. The initial percentage margin is 60%. If the price of the
stock falls to ` 57.14, the value of his stock will be ` 5,714. Since the loan is ` 4,000, the percentage
margin now is (5,714 - 4,000) / 5714 = 29.9%. The investor will get a margin call.

When investors acquire stock or other investments on margin, they are increasing the financial
risk of the investment beyond the risk inherent in the security itself. They should increase their
required rate of return accordingly.
Return on margin transaction = (change in investor's equity - interest - commission)/initial
investor's equity

Example: Suppose an investor is bullish (optimistic) on Microsoft stock, which is currently
selling at ` 100 per share. The investor has ` 10,000 to invest and expects the stock to go up in
price by 30% during the next year. Ignoring any dividends and commissions, the expected rate
of return would thus be 30% if the investor spent only ` 10,000 to buy 100 shares. If the investor
borrows ` 10,000 from his broker and invest it in the stock (along with his own ` 10,000). Assume
that the interest rate is 9% per year.
1. If the stock goes up to 30%, his 200 shares will be worth ` 26,000. After paying off ` 10,000
of principal and interest on the margin load leaves ` 15,100. The rate of return, therefore
will be (` 15,100 - ` 10,000) / ` 10,000 = 51%. Good investment, huh?

110 LOVELY PROFESSIONAL UNIVERSITY