Margin finance: Encyclopedia II - Margin finance - Margin buying

Margin finance - Margin buying

Jean buys a share in Universal Widgets SA for ¢100, using ¢20 of his own money, and ¢80 borrowed from his broker. The net value (share minus loan) is ¢20. The broker wants a minimum margin requirement of ¢10.

Suppose the share goes down to ¢85. The net value is now only ¢5, and Jean will either have to sell the share or repay part of the loan (so that the net value of his position is again above ¢10).

Margin buying is buying securities with some own cash together with cash borrowed from a broker. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the own cash used. This difference has to stay above a minimum margin requirement. This is to protect the broker against a fall in the value of the securities to the point that they no longer cover the loan.

In the 1920's, margin requirements were loose. In other words, brokers required investors to put in very little of their own money. When stock markets plummetted, the net value of the positions rapidly fell below the minimum margin requirements, forcing investors to sell their positions. This was one important factor contributing to the Stock Market Crash of 1929, which in turn is thought to have contributed to the Great Depression.

Adapted from the Wikipedia article "Margin buying", under the G.N U Free Docmentation License. Please also see http://en.wikipedia.org/wiki